OLD SECOND BANCORP INC - Quarter Report: 2018 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q


☒	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
	THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2018


☐	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
	SECURITIES EXCHANGE ACT OF 1934

For transition period from to

Commission File Number 0-10537

(Exact name of Registrant as specified in its charter)


Delaware		36-3143493
(State or other jurisdiction		(I.R.S. Employer Identification Number)
of incorporation or organization)

37 South River Street, Aurora, Illinois 60507

(Address of principal executive offices) (Zip Code)

(630) 892-0202

(Registrant’s telephone number, including area code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes ☒ No ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of ‘‘large accelerated filer,’’ ‘‘accelerated filer,’’ ‘‘smaller reporting company,’’ and ‘‘emerging growth company’’ in Rule 12b–2 of the Exchange Act.

Large accelerated filer☐Accelerated filer☒

Non-accelerated filer☐Smaller reporting company☐Emerging growth company☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2).

Yes ☐ No ☒

As of November 2, 2018, the Registrant had 29,758,578 shares of common stock outstanding at $1.00 par value per share.

Table of Contents

OLD SECOND BANCORP, INC.

Form 10-Q Quarterly Report

Table of Contents

Cautionary Note Regarding Forward Looking Statements


	PART I
		Page Number
Item 1.	Financial Statements	4
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	38
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	55
Item 4.	Controls and Procedures	56
	PART II

Item 1.	Legal Proceedings	56
Item 1.A.	Risk Factors	56
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	57
Item 3.	Defaults Upon Senior Securities	57
Item 4.	Mine Safety Disclosure	57
Item 5.	Other Information	57
Item 6.	Exhibits	57

	Signatures	58

Table of Contents

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This report and other publicly available documents of the Company, including the documents incorporated herein by reference, contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act, including, but not limited to, statements regarding management’s belief that we are positioned for future growth, expectations regarding future plans, strategies and financial performance, regulatory developments, industry and economic trends, and other matters. Forward-looking statements, which may be based upon beliefs, expectations and assumptions of the Company's management and on information currently available to management, can be identified by the inclusion of such qualifications as “expects,” “intends,” “believes,” “may,” “will,” “would,” “could,” “should,” “plan,” “anticipate,” “estimate,” “seeks,” “possible,” “likely” or other indications that the particular statements are not historical facts and refer to future periods. Because forward-looking statements relate to the future, they are subject to inherent uncertainties, risks and changes in circumstances that are difficult to predict and may be outside of the Company’s control. Actual events and results may differ significantly from those described in such forward-looking statements, due to numerous factors, including:

negative economic conditions that adversely affect the economy, real estate values, the job market and other factors nationally and in our market area, in each case that may affect our liquidity and the performance of our loan portfolio;

defaults and losses on our loan portfolio;

the anticipated benefits of the Company’s recent merger with Greater Chicago Financial Corp., including estimated cost savings and anticipated strategic gains, may be significantly harder or take longer to achieve than expected or may not be achieved in their entirety as a result of unexpected factors or events;

the integration of Greater Chicago Financial Corp.’s business and operations into the Company, which included conversion of Greater Chicago Financial Corp.’s operating systems and procedures, may have unanticipated adverse results relating to the Company’s existing businesses;

the Company’s ability to achieve anticipated results from the Greater Chicago Financial Corp. transaction is dependent on the state of the economic and financial markets going forward. Specifically, the Company may incur more credit losses than expected, cost savings may be less than expected and customer attrition may be greater than expected;

risks related to potential mergers and acquisitions including potential deposit attrition, higher than expected costs, customer loss and business disruption, including, without limitation, potential difficulties in maintaining relationships with key personnel and other integration related-matters, and the potential inability to identify and successfully negotiate and complete additional successful combinations with potential merger or acquisition partners;

the financial success and viability of the borrowers of our commercial loans;

market conditions in the commercial and residential real estate markets in our market area;

changes in U.S. monetary policy, the level and volatility of interest rates, the capital markets and other market conditions that may affect, among other things, our liquidity and the value of our assets and liabilities;

competitive pressures in the financial services business;

any negative perception of our reputation or financial strength;

ability to raise additional capital on acceptable terms when needed;

ability to use technology to provide products and services that will satisfy customer demands and create efficiencies in operations;

adverse effects on our information technology systems resulting from failures, human error or cyberattacks;

adverse effects of failures by our vendors to provide agreed upon services in the manner and at the cost agreed, particularly our information technology vendors;

the impact of any claims or legal actions, including any effect on our reputation;

losses incurred in connection with repurchases and indemnification payments related to mortgages;

the soundness of other financial institutions;

changes in accounting standards, rules and interpretations and the impact on our financial statements;

our ability to receive dividends from our subsidiaries;

a decrease in our regulatory capital ratios;

legislative or regulatory changes, particularly changes in regulation of financial services companies;

increased costs of compliance, heightened regulatory capital requirements and other risks associated with changes in regulation and the current regulatory environment, including the Dodd-Frank Act;

the impact of heightened capital requirements; and

each of the factors and risks under the heading “Risk Factors” in our 2017 Form 10-K and Form 10-Qs filed with the SEC.

Because the Company’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain, there can be no assurances that future actual results will correspond to any forward-looking statements and you should not rely on any forward-looking statements. Additionally, all statements in this Form 10-Q, including forward-looking statements, speak only as of the date they are made, and the Company undertakes no obligation to update any statement in light of new information or future events.

Table of Contents

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

Old Second Bancorp, Inc. and Subsidiaries

Consolidated Balance Sheets

(In thousands, except share data)


	(unaudited)
	September 30,		December 31,
	2018		2017
Assets
Cash and due from banks	$	34,366	$	37,444
Interest bearing deposits with financial institutions		15,956		18,389
Cash and cash equivalents		50,322		55,833
Securities available-for-sale, at fair value		542,338		541,439
Federal Home Loan Bank Chicago ("FHLBC") and Federal Reserve Bank Chicago ("FRBC") stock		10,511		10,168
Loans held-for-sale		2,911		4,067
Loans		1,834,949		1,617,622
Less: allowance for loan and lease losses		19,328		17,461
Net loans		1,815,621		1,600,161
Premises and equipment, net		42,752		37,628
Other real estate owned		6,964		8,371
Mortgage servicing rights, net		8,131		6,944
Goodwill and core deposit intangible		21,947		8,922
Bank-owned life insurance ("BOLI")		61,506		61,764
Deferred tax assets, net		25,116		25,356
Other assets		24,354		22,776
Total assets	$	2,612,473	$	2,383,429

Liabilities
Deposits:
Noninterest bearing demand	$	621,580	$	572,404
Interest bearing:
Savings, NOW, and money market		1,045,886		967,750
Time		464,904		382,771
Total deposits		2,132,370		1,922,925
Securities sold under repurchase agreements		44,333		29,918
Other short-term borrowings		81,875		115,000
Junior subordinated debentures		57,674		57,639
Senior notes		44,133		44,058
Notes payable and other borrowings		18,050		-
Other liabilities		15,908		13,539
Total liabilities		2,394,343		2,183,079

Stockholders’ Equity
Common stock		34,717		34,626
Additional paid-in capital		118,625		117,742
Retained earnings		167,140		142,959
Accumulated other comprehensive (loss) income		(6,058)		1,479
Treasury stock		(96,294)		(96,456)
Total stockholders’ equity		218,130		200,350
Total liabilities and stockholders’ equity	$	2,612,473	$	2,383,429


	September 30, 2018		December 31, 2017
	Common		Common
	Stock		Stock
Par value	$	1.00	$	1.00
Shares authorized		60,000,000		60,000,000
Shares issued		34,716,589		34,625,734
Shares outstanding		29,747,078		29,627,086
Treasury shares		4,969,511		4,998,648

See accompanying notes to consolidated financial statements.

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Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Income

(In thousands, except per share data)


	(unaudited)				(unaudited)
	Three Months Ended September 30,				Nine Months Ended September 30,
	2018		2017		2018		2017
Interest and dividend income
Loans, including fees	$	23,377	$	18,208	$	64,625	$	52,202
Loans held-for-sale		39		34		94		95
Securities:
Taxable		2,491		2,424		7,053		7,994
Tax exempt		2,064		1,628		6,239		4,188
Dividends from FHLBC and FRBC stock		121		94		338		271
Interest bearing deposits with financial institutions		84		37		230		91
Total interest and dividend income		28,176		22,425		78,579		64,841
Interest expense
Savings, NOW, and money market deposits		642		239		1,487		695
Time deposits		1,568		1,077		4,187		3,081
Securities sold under repurchase agreements		140		4		323		10
Other short-term borrowings		311		220		916		472
Junior subordinated debentures		930		930		2,784		3,073
Senior notes		672		672		2,016		2,017
Notes payable and other borrowings		173		-		268		-
Total interest expense		4,436		3,142		11,981		9,348
Net interest and dividend income		23,740		19,283		66,598		55,493
Provision for loan and lease losses		-		300		728		1,050
Net interest and dividend income after provision for loan and lease losses		23,740		18,983		65,870		54,443
Noninterest income
Trust income		1,644		1,468		4,784		4,564
Service charges on deposits		1,923		1,722		5,284		4,955
Secondary mortgage fees		199		195		556		594
Mortgage servicing rights mark to market (loss) gain		(11)		(194)		189		(756)
Mortgage servicing income		471		451		1,550		1,330
Net gain on sales of mortgage loans		965		1,095		3,122		3,715
Securities gains (losses), net		13		102		360		(165)
Increase in cash surrender value of BOLI		347		362		946		1,071
Death benefit realized on bank-owned life insurance		-		-		1,026		-
Debit card interchange income		1,135		1,075		3,279		3,131
Gain on disposal and transfer of fixed assets, net		-		-		-		10
Other income		1,128		1,567		3,755		3,739
Total noninterest income		7,814		7,843		24,851		22,188
Noninterest expense
Salaries and employee benefits		11,165		10,049		33,727		31,167
Occupancy, furniture and equipment		1,782		1,482		4,992		4,510
Computer and data processing		1,247		1,081		5,332		3,283
FDIC insurance		162		199		483		512
General bank insurance		230		246		780		780
Amortization of core deposit intangible		136		24		254		74
Advertising expense		492		255		1,325		1,093
Debit card interchange expense		320		285		902		1,033
Legal fees		243		162		688		450
Other real estate expense, net		(370)		680		232		1,928
Other expense		3,304		2,455		9,636		8,128
Total noninterest expense		18,711		16,918		58,351		52,958
Income before income taxes		12,843		9,908		32,370		23,673
Provision for income taxes		3,201		1,831		6,978		6,023
Net income available to common stockholders	$	9,642	$	8,077	$	25,392	$	17,650

Basic earnings per share	$	0.32	$	0.27	$	0.85	$	0.60
Diluted earnings per share		0.32		0.27		0.84		0.59
Dividends declared per share		0.01		0.01		0.03		0.03

See accompanying notes to consolidated financial statements.

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Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Comprehensive Income

(In thousands)


	(unaudited)				(unaudited)
	Three Months Ended September 30,				Nine Months Ended September 30,
	2018		2017		2018		2017
Net Income	$	9,642	$	8,077	$	25,392	$	17,650

Unrealized holding (losses) gains on available-for-sale securities arising during the period		(2,801)		2,971		(12,999)		13,798
Related tax benefit (expense)		788		(1,191)		3,664		(5,556)
Holding (losses) gains after tax on available-for-sale securities		(2,013)		1,780		(9,335)		8,242

Less: Reclassification adjustment for the net gains (losses) realized during the period
Net realized gains (losses)		12		102		360		(165)
Related tax (expense) benefit		(2)		(42)		(100)		24
Net realized gains (losses) after tax		10		60		260		(141)
Other comprehensive (loss) income on available-for-sale securities		(2,023)		1,720		(9,595)		8,383

Changes in fair value of derivatives used for cash flow hedges		628		19		2,422		(445)
Related tax (expense) benefit		(176)		8		(683)		192
Other comprehensive income on cash flow hedges		452		27		1,739		(253)

Total other comprehensive (loss) income		(1,571)		1,747		(7,856)		8,130
Total comprehensive income	$	8,071	$	9,824	$	17,536	$	25,780

See accompanying notes to consolidated financial statements.

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Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(In thousands)


	(Unaudited)
	Nine Months Ended September 30,
	2018		2017
Cash flows from operating activities
Net income	$	25,392	$	17,650
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation of fixed assets and amortization of leasehold improvements		1,778		1,760
Change in fair value of mortgage servicing rights		(189)		756
Provision for loan and lease losses		728		1,050
Provision for deferred tax expense		6,777		5,682
Originations of loans held-for-sale		(107,947)		(113,077)
Proceeds from sales of loans held-for-sale		111,169		119,059
Net gains on sales of mortgage loans		(3,122)		(3,715)
Net discount (accretion)/premium amortization of purchase accounting adjustment on loans		(776)		(1,115)
Change in current income taxes receivable		671		111
Increase in cash surrender value of BOLI		(946)		(1,071)
Change in accrued interest receivable and other assets		533		(6,849)
Change in accrued interest payable and other liabilities		2,432		4,571
Net premium amortization/discount (accretion) on securities		2,128		1,320
Securities (gains) losses, net		(360)		165
Amortization of core deposit intangible		254		74
Amortization of junior subordinated debentures issuance costs		35		36
Amortization of senior notes issuance costs		75		77
Stock based compensation		1,641		897
Net gains on sale of other real estate owned		(716)		(454)
Provision for other real estate owned valuation losses		485		1,630
Net losses on disposal and transfer of fixed assets		-		(10)
Net cash provided by operating activities		40,042		28,547
Cash flows from investing activities
Proceeds from maturities and calls including pay down of securities available-for-sale		32,890		105,327
Proceeds from sales of securities available-for-sale		94,663		152,476
Purchases of securities available-for-sale		(71,488)		(246,971)
Net disbursements/proceeds from sales (purchases) of FHLBC stock		2,627		(2,475)
Net disbursements/proceeds from (purchases) sales of FRB stock		(1,421)		-
Net change in loans		9,988		(118,711)
Proceeds from claims on BOLI, net of premiums paid		1,204		-
Improvements in other real estate owned		(59)		-
Proceeds from sales of other real estate owned, net of participation purchase		4,292		5,512
Proceeds from disposition of premises and equipment		-		13
Net purchases of premises and equipment		(1,563)		(852)
Cash paid for acquisition, net of cash and cash equivalents retained		(35,711)		-
Net cash provided by (used in) investing activities		35,422		(105,681)
Cash flows from financing activities
Net change in deposits		(39,053)		22,330
Net change in securities sold under repurchase agreements		8,792		1,138
Net change in other short-term borrowings		(44,000)		55,000
Payment of senior note issuance costs		-		(42)
Net change in notes payable and other borrowings		(5,317)		-
Dividends paid on common stock		(892)		(888)
Purchase of treasury stock		(505)		(236)
Net cash (used in) provided by financing activities		(80,975)		77,302
Net change in cash and cash equivalents		(5,511)		168
Cash and cash equivalents at beginning of period		55,833		47,334
Cash and cash equivalents at end of period	$	50,322	$	47,502

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Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Cash Flows - Continued

(In thousands)



	Nine Months Ended September 30,
Supplemental cash flow information	2018		2017
Income taxes paid, net	$	-	$	230
Interest paid for deposits		5,381		3,802
Interest paid for borrowings		5,482		4,890
Non-cash transfer of loans to other real estate owned		2,194		3,701
Non-cash transfer of premises to other real estate owned		-		95

See accompanying notes to consolidated financial statements.

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Old Second Bancorp, Inc. and Subsidiaries

Consolidated Statements of Changes in

Stockholders’ Equity

(In thousands)


							Accumulated
			Additional				Other				Total
	Common		Paid-In		Retained		Comprehensive		Treasury		Stockholders’
	Stock		Capital		Earnings		Income (Loss)		Stock		Equity
Balance, December 31, 2016	$	34,534	$	116,653	$	129,005	$	(8,762)	$	(96,220)	$	175,210
Net income						17,650						17,650
Other comprehensive income, net of tax								8,130				8,130
Dividends declared and paid, ($0.03 per share)						(888)						(888)
Vesting of restricted stock		92		(92)								-
Stock based compensation				897								897
Purchase of treasury stock										(236)		(236)
Balance, September 30, 2017	$	34,626	$	117,458	$	145,767	$	(632)	$	(96,456)	$	200,763

Balance, December 31, 2017	$	34,626	$	117,742	$	142,959	$	1,479	$	(96,456)	$	200,350
Net income						25,392						25,392
Other comprehensive loss, net of tax								(7,856)				(7,856)
Dividends declared and paid, ($0.03 per share)						(892)						(892)
Vesting of restricted stock		91		(758)						667		-
Reclassification of stranded tax effects						(319)		319				-
Stock based compensation				1,641								1,641
Purchase of treasury stock										(505)		(505)
Balance, September 30, 2018	$	34,717	$	118,625	$	167,140	$	(6,058)	$	(96,294)	$	218,130

See accompanying notes to consolidated financial statements.

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Note 1 – Summary of Significant Accounting Policies

The accounting policies followed in the preparation of the interim consolidated financial statements are consistent with those used in the preparation of the annual financial information. The interim consolidated financial statements reflect all normal and recurring adjustments that are necessary, in the opinion of management, for a fair statement of results for the interim period presented. Results for the period ended September 30, 2018, are not necessarily indicative of the results that may be expected for the year ending December 31, 2018. These interim consolidated financial statements are unaudited and should be read in conjunction with the audited financial statements and notes included in Old Second Bancorp, Inc.’s (the “Company”) annual report on Form 10-K for the year ended December 31, 2017. Unless otherwise indicated, amounts in the tables contained in the notes to the consolidated financial statements are in thousands. Certain items in prior periods have been reclassified to conform to the current presentation.

The Company’s consolidated financial statements are prepared in accordance with United States generally accepted accounting principles (“GAAP”) and follow general practices within the banking industry. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the consolidated financial statements. Future changes in information may affect these estimates, assumptions, and judgments, which, in turn, may affect amounts reported in the consolidated financial statements.

Significant accounting policies are presented in Note 1 to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017. These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets and liabilities are valued in the consolidated financial statements and how those values are determined.

In addition to the significant accounting policies presented in our Form 10-K, as noted above, as a result of our acquisition of Greater Chicago Financial Corp. (“GCFC”), and its wholly-owned subsidiary, ABC Bank, that closed in the second quarter of 2018, the Company has implemented accounting policies regarding purchased loans. Loans purchased as a result of a business combination are recorded at estimated fair value on the acquisition date, with no carryover of the related allowance for loan and lease losses recorded by the acquiree at the time of purchase. These loans are segregated into two classifications upon purchase:

purchased non-credit impaired (“non-PCI”) loans, accounted for in accordance with FASB ASC Subtopic 310-20 “Nonrefundable Fees and Costs” (“ASC 310-20”), which have a discount attributable in part to credit quality. Premiums and discounts created when ASC 310-20 loans are recorded at their fair values at acquisition are amortized over the remaining terms of the loans as an adjustment to the related loan’s yield; and

purchased credit impaired (“PCI”) loans, accounted for under FASB ASC Subtopic 310-30, “Loans and Debt Securities Acquired with Deteriorated Credit Quality” (“ASC 310-30”) as they display signs of credit deterioration. Interest income, through accretion of the difference between the carrying value of the loans and the expected cash flows, is recognized on the acquired loans accounted for under ASC 310-30.

Recent Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09 “Revenue from Contracts with Customers (Topic 606).” The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services. In August 2015, the FASB issued ASU 2015-14 “Revenue from Contracts with Customers (Topic 606) Deferral of the Effective Date,” which deferred the effective date of ASU 2014-09 for an additional year. ASU 2015-14 was effective for annual reporting periods beginning after December 15, 2017. The amendments could be applied retrospectively to each prior reporting period or retrospectively with the cumulative effect of initially applying this update recognized at the date of initial application. Early application was not permitted. In March 2016, the FASB issued ASU 2016-08 “Revenue from Contracts with Customers (TOPIC 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net)” and in April 2016, the FASB issued ASU 2016-10 “Revenue from Contracts with Customers (TOPIC 606): Identifying Performance Obligations and Licensing.” ASU 2016-08 requires the entity to determine if it is acting as a principal with control over the goods or services it is contractually obligated to provide, or an agent with no control over specified goods or services provided by another party to a customer. ASU 2016-10 was issued to further clarify ASU 2014-09 implementation regarding identifying performance obligation materiality, identification of key contract components, and scope.

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

The Company performed an analysis of the impact of adoption of this ASU, reviewing revenue recorded from service charges on deposit accounts, asset management fees, gains (losses) on other real estate owned, and debit card interchange fees. Certain revenue received, such as service charges on deposit accounts and interchange fees, is recorded immediately or as the service is performed. Asset management fees recorded by the Company take the form of wealth management income and brokerage income, and both types of fees are recorded after services are rendered, with no contractual requirement of refund to a customer based on non-achievement of fund performance objectives. Finally, the methodology used to record revenue from gains (losses) due to the sale of other real estate owned is not anticipated to change, as the Company currently records income or expense only upon consummation of the sale, and any revenue recorded stemming from seller financed transactions is reviewed for deferral, as appropriate. The Company adopted ASU 2014-09 and related issuances on January 1, 2018, with no cumulative effect adjustment to opening retained earnings required upon implementation of this standard.

In January 2016, the FASB issued ASU No. 2016-01 “Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities.” The objective of the issuance is to provide users of financial statements with more decision–useful information, by making targeted improvements to GAAP. These targeted improvements included revisions to the methodology of accounting for equity investments, eliminating certain disclosures on fair value assumptions for financial instruments measured at amortized cost, and requiring public business entities to use the exit price notion, as defined in ASC 820, for the measurement of the fair value of financial instruments. This standard was effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company adopted this standard as of January 1, 2018. Adoption of this standard resulted in the Company’s use of an exit price rather than an entrance price to determine the fair value of loans and deposits not already measured at fair value on a non-recurring basis in the consolidated balance sheet disclosures; see Note 14–Fair Value of Financial Instruments for further information regarding the valuation processes.

In February 2016, the FASB issued ASU No. 2016-02 “Leases (Topic 842).” This ASU was issued to increase transparency and comparability among organizations by recognizing lease assets and liabilities on the balance sheet and disclosing key information about leasing arrangements. One key revision from prior guidance was to include operating leases within assets and liabilities recorded; another revision was to create a new model to follow for sale-leaseback transactions. The impact of this pronouncement will primarily affect lessees, as virtually all of their assets will be recognized on the balance sheet, by recording a right of use asset and lease liability. This pronouncement is effective for fiscal years beginning after December 15, 2018. In July 2018, the FASB issued ASU No. 2018-11, “Leases (Topic 842): Targeted Improvements” which provided additional guidance on the transition method, including application as a cumulative-effect adjustment to equity and practical expedients to use when accounting for lease components. The Company is in the process of identifying the population of all lease arrangements and an implementation team is currently assessing the impact of the ASU on the Company’s processes, accounting, internal controls over financial reporting, and regulatory capital.

In June 2016, the FASB issued ASU No. 2016-13 “Measurement of Credit Losses on Financial Instruments (Topic 326).” ASU 2016-13 was issued to provide financial statement users with more useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date to enhance the decision making process. The new methodology to be used should reflect expected credit losses based on relevant vintage historical information, supported by reasonable forecasts of projected loss given defaults, which will affect the collectability of the reported amounts. This new methodology will also require available-for-sale debt securities to have a credit loss recorded through an allowance rather than write-downs. ASU 2016-13 is effective for financial statements issued for fiscal years beginning after December 15, 2019. The Company is assessing the impact of ASU 2016-13 on its accounting and disclosures, and has determined that a loss rate model will be used for calculation of future risk assessments upon the ASU’s adoption in 2020. The Company has accumulated historical data by loan pools and collateral classifications, and anticipates calculation of estimates for at least two quarters in 2019 on a test basis to confirm model processes and to determine financial statement impact prior to adoption in 2020.

In March 2017, the FASB issued ASU No. 2017-08 “Receivables-Nonrefundable Fees and Other Costs – Premium Amortization on Purchased Callable Debt Securities (Subtopic 310-20).” This ASU was issued to shorten the amortization period for the premium to the earliest call date on debt securities. This premium is required to be recorded as a reduction to net interest margin during the shorter yield to call period, as compared to prior practice of amortizing the premium as a reduction to net interest margin over the contractual life of the instrument. This ASU does not change the current method of amortizing any discount over the contractual life of the debt security, and this pronouncement is effective for fiscal years beginning after December 15, 2018, with earlier adoption permitted. The Company adopted ASU 2017-08 as a change in accounting principle in the third quarter of 2017 on a modified retrospective basis, which required the Company to reflect its adoption effective January 1, 2017. The effect of amortizing the premium over a shorter period will continue to decrease future quarterly net interest income over the call period until the premium is fully amortized. As a result of management’s analysis, the impact of the change in accounting principle as a result of ASU 2017-08 to adjust beginning of year retained earnings was considered insignificant and, accordingly, the impact was adjusted through 2017 earnings.

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

In August 2017, the FASB issued ASU No. 2017-12, “Derivatives and Hedging: Targeted Improvements to Accounting for Hedging Activities”. The purpose of this updated guidance is to better align a company’s financial reporting for hedging activities with the economic objectives of those activities. ASU 2017-12 is effective for public business entities for fiscal years beginning after December 15, 2018, with early adoption, including adoption in an interim period, permitted. The Company adopted ASU 2017-12 on January 1, 2018, on a modified retrospective basis. FASB ASC 815, Derivatives and Hedging (“ASC 815”), provides the disclosure requirements for derivatives and hedging activities with the intent to provide users of financial statements with an enhanced understanding of: (a) how and why an entity uses derivative instruments, (b) how the entity accounts for derivative instruments and related hedged items, and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. Further, qualitative disclosures are required that explain the Company’s objectives and strategies for using derivatives, as well as quantitative disclosures about the fair value of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative instruments.

As required by ASC 815, the Company records all derivatives on the balance sheet at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether the Company has elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Derivatives may also be designated as hedges of the foreign currency exposure of a net investment in a foreign operation. Hedge accounting generally provides for the matching of the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk in a fair value hedge or the earnings effect of the hedged forecasted transactions in a cash flow hedge. The Company may enter into derivative contracts that are intended to economically hedge certain of its risk, even though hedge accounting does not apply or the Company elects not to apply hedge accounting.

In accordance with the FASB’s fair value measurement guidance in ASU 2011-04, the Company made an accounting policy election to measure the credit risk of its derivative financial instruments that are subject to master netting agreements on a net basis by counterparty portfolio. As the Company does not currently have any derivative financial instruments subject to master netting agreements, there was no impact to the balance sheet.

In February 2018, the FASB issued ASU No. 2018-02, “Income Statement-Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income.” This ASU was issued in response to the enactment of tax bill H.R.1 “Tax Cuts and Jobs Act”, which resulted in “stranding” the tax effects of items within accumulated other comprehensive income related to the adjustment of deferred taxes due to the reduction of the federal corporate income tax rate. The amendments proposed allow the reclassification of these stranded tax effects to retained earnings, and were effective for all entities for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption is permitted, and should be applied either in the period of adoption or retrospectively to each period in which the effect of the change in the U.S. federal corporate tax rate is recognized. The Company adopted ASU 2018-02 as of January 1, 2018, and a reclassification of $319,000, net, was recorded, which increased accumulated other comprehensive income and reduced retained earnings with the adoption of the accounting standard.

Subsequent Events

On October 16, 2018, the Company’s Board of Directors declared a cash dividend of $0.01 per share payable on November 5, 2018, to stockholders of record as of October 26, 2018; dividends of $298,000 were paid to stockholders on November 5, 2018.

Note 2 – Acquisitions

On April 20, 2018, the Company acquired GCFC and its wholly owned subsidiary, ABC Bank, which operated four branches in the Chicago metro area. In addition to the acquisition price of $41.1 million, the Company retired the convertible and nonconvertible debentures held by GCFC upon acquisition, which totaled $6.6 million, including interest due. The purchase and the retirement of the debentures was funded with the Company’s cash on hand, and all GCFC common stock was retired and cancelled simultaneous with the close of the transaction. The Company acquired $227.6 million of loans, net of purchase accounting adjustments, and $248.5 million of deposits, net of purchase accounting adjustments for time deposits. Purchase accounting adjustments recorded in the second quarter of 2018 include a loan valuation mark of $11.2 million, a core deposit intangible of $3.1 million, a fixed asset valuation adjustment of $1.5 million, and goodwill of $9.9 million. In addition, a deferred tax asset of $3.5 million was recorded as of the date of acquisition based on analysis of the fair value of assets acquired, less liabilities assumed. None of the $9.9 million recorded as goodwill is expected to be deductible for tax purposes. Acquisition related costs incurred by the Company for the nine months ended

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

September 30, 2018, totaled $3.3 million, pre-tax, and included $1.0 million of salaries and employee benefits related expenses, and $1.8 million of data processing, computer and ATM related conversion costs.

The assets and liabilities associated with the acquisition of GCFC were recorded in the Consolidated Balance Sheets at their estimated fair values as of the acquisition date. In many cases the determination of these fair values required management to make estimates about discount rates, future expected cash flows, market conditions and other future events that are highly subjective in nature and subject to change, as noted below. The following table shows the estimated fair value of the assets acquired and liabilities assumed as of April 20, 2018. These fair value estimates are preliminary and subject to refinement for up to one year after the closing date of the acquisition or the date we receive the information about the facts and circumstances that existed at the acquisition date. Subsequent adjustments are, and if necessary, will be prospectively reflected in future filings, and may impact loans, other assets, deferred tax assets, net, and goodwill.

The below table summarizes the assets acquired, less the liabilities assumed, related to the GCFC/ABC Bank acquisition. All amounts are listed at their estimated fair values as of date of acquisition, and have been accounted for under the acquisition method of accounting.


GCFC/ABC Bank Acquisition Summary
As of Date of Acquisition
		April 20, 2018
Assets
Cash and due from banks	$	6,669
Interest bearing deposits with financial institutions		500
Securities available-for-sale, at fair value		72,091
Federal funds sold		4,300
FHLBC stock		1,549
Loans		227,594
Premises and equipment		5,339
Other real estate owned		401
Goodwill and core deposit intangible		12,966
Deferred tax assets, net		3,459
Other assets		1,925
Total assets	$	336,793

Liabilities
Noninterest bearing demand	$	58,005
Savings, NOW and money market		91,494
Time		98,999
Total deposits		248,498
Securities sold under repurchase agreements		5,624
Other short-term borrowings		10,875
Notes payable and other borrowings		23,367
Other liabilities		1,249
Total liabilities		289,613

Cash consideration paid		47,180
Total Liabilities Assumed and Cash Consideration Paid for Acquisition	$	336,793

Loans acquired in the GCFC acquisition were initially recorded at fair value with no separate allowance for loan losses. The Company reviewed the loans at acquisition to determine which loans should be considered PCI loans, defining impaired loans as those that were either not accruing interest or exhibited credit risk factors consistent with nonperforming loans at the acquisition date, or non-PCI loans, as addressed in the Company’s significant accounting policies.

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

The following table represents the acquired loans as of date of acquisition and as of September 30, 2018:


	April 20, 2018				September 30, 2018
ABC Bank Acquired Loans	PCI		Non-PCI		PCI		Non-PCI
Fair Value	$	11,360	$	216,306	$	10,887	$	201,289
Contractually required principal and interest payment		19,447		219,488		18,174		203,156
Best estimate of contractual cash flows not expected to be collected		6,537		2,511		6,069		1,457
Best estimate of contractual cash flows expected to be collected		12,910		216,977		12,105		201,699

Note 3 – Securities

Investment Portfolio Management

Our investment portfolio serves the liquidity needs and income objectives of the Company. While the portfolio serves as an important component of the overall liquidity management at the Bank, portions of the portfolio also serve as income producing assets. The size and composition of the portfolio reflects liquidity needs, loan demand and interest income objectives. Portfolio size and composition will be adjusted from time to time. While a significant portion of the portfolio consists of readily marketable securities to address liquidity, other parts of the portfolio may reflect funds invested pending future loan demand or to maximize interest income without undue interest rate risk.

Investments are comprised of debt securities and non-marketable equity investments. Securities available-for-sale are carried at fair value. Unrealized gains and losses, net of tax, on securities available-for-sale are reported as a separate component of equity. This balance sheet component changes as interest rates and market conditions change. Unrealized gains and losses are not included in the calculation of regulatory capital.

FHLBC and FRBC stock are considered nonmarketable equity investments. FHLBC stock was recorded at $4.3 million at September 30, 2018, and $5.4 million at December 31, 2017. FRBC stock was recorded at $6.2 million and $4.8 million at September 30, 2018, and December 31, 2017, respectively.

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

The following table summarizes the amortized cost and fair value of the securities portfolio at September 30, 2018, and December 31, 2017, and the corresponding amounts of gross unrealized gains and losses:


			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
September 30, 2018	Cost		Gains		Losses		Value
Securities available-for-sale
U.S. Treasuries	$	4,005	$	-	$	(151)	$	3,854
U.S. government agencies		11,881		-		(178)		11,703
U.S. government agencies mortgage-backed		15,474		-		(708)		14,766
States and political subdivisions		278,604		398		(6,738)		272,264
Collateralized mortgage obligations		67,762		118		(2,920)		64,960
Asset-backed securities		108,622		991		(440)		109,173
Collateralized loan obligations		65,555		162		(99)		65,618
Total securities available-for-sale	$	551,903	$	1,669	$	(11,234)	$	542,338


			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
December 31, 2017	Cost		Gains		Losses		Value
Securities available-for-sale
U.S. Treasury	$	4,002	$	-	$	(55)	$	3,947
U.S. government agencies		13,062		8		(9)		13,061
U.S. government agencies mortgage-backed		12,372		7		(165)		12,214
States and political subdivisions		272,240		7,116		(1,264)		278,092
Corporate bonds		823		21		(11)		833
Collateralized mortgage obligations		66,892		202		(1,155)		65,939
Asset-backed securities		113,983		862		(1,913)		112,932
Collateralized loan obligations		54,271		251		(101)		54,421
Total securities available-for-sale	$	537,645	$	8,467	$	(4,673)	$	541,439

The fair value, amortized cost and weighted average yield of debt securities at September 30, 2018, by contractual maturity, were as follows in the table below. Securities not due at a single maturity date are shown separately.


			Weighted
	Amortized		Average		Fair
Securities available-for-sale	Cost		Yield		Value
Due in one year or less	$	1,500	4.78	%	$	1,502
Due after one year through five years		4,005	1.85			3,854
Due after five years through ten years		6,688	3.03			6,626
Due after ten years		282,297	3.00			275,839
		294,490	3.00			287,821
Mortgage-backed and collateralized mortgage obligations		83,236	3.21			79,726
Asset-backed securities		108,622	3.22			109,173
Collateralized loan obligations		65,555	4.71			65,618
Total securities available-for-sale	$	551,903	3.28	%	$	542,338

At September 30, 2018, the Company’s investments included $92.6 million of asset-backed securities that are backed by student loans originated under the Federal Family Education Loan program (“FFEL”). Under the FFEL, private lenders made federally guaranteed student loans to parents and students. While the program was modified several times before elimination in 2010, FFEL securities are generally guaranteed by the U.S Department of Education (“DOE”) at not less than 97% of the outstanding principal amount of the loans. The guarantee will reduce to 85% if the DOE receives reimbursement requests in excess of 5% of insured loans; reimbursement will drop to 75% if reimbursement requests exceed 9% of insured loans. In addition to the DOE guarantee, total added credit enhancement in the form of overcollateralization and/or subordination amounted to $11.7 million, or 12.44% of outstanding principal.

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

The Company has invested in securities issued from three originators that individually amount to over 10% of the Company’s stockholders equity. Information regarding these three issuers and the value of the securities issued follows:


	September 30, 2018
	Amortized		Fair
Issuer	Cost		Value
GCO Education Loan Funding Corp	$	27,711	$	27,788
Towd Point Mortgage Trust		34,390		33,181
Student Loan Marketing Association		25,798		26,134

Securities with unrealized losses at September 30, 2018, and December 31, 2017, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows (in thousands except for number of securities):


	Less than 12 months					12 months or more
September 30, 2018	in an unrealized loss position					in an unrealized loss position					Total
	Number of	Unrealized		Fair		Number of	Unrealized		Fair		Number of	Unrealized		Fair
Securities available-for-sale	Securities	Losses		Value		Securities	Losses		Value		Securities	Losses		Value
U.S. Treasuries	-	$	-	$	-	1	$	151	$	3,854	1	$	151	$	3,854
U.S. government agencies	3		109		7,829	1		69		3,874	4		178		11,703
U.S. government agencies mortgage-backed	6		287		7,357	7		421		7,409	13		708		14,766
States and political subdivisions	55		3,843		174,924	9		2,895		28,218	64		6,738		203,142
Collateralized mortgage obligations	4		714		25,620	8		2,206		33,342	12		2,920		58,962
Asset-backed securities	3		79		7,526	5		361		30,240	8		440		37,766
Collateralized loan obligations	4		85		24,502	1		14		7,986	5		99		32,488
Total securities available-for-sale	75	$	5,117	$	247,758	32	$	6,117	$	114,923	107	$	11,234	$	362,681


	Less than 12 months					12 months or more
December 31, 2017	in an unrealized loss position					in an unrealized loss position					Total
	Number of	Unrealized			Fair	Number of	Unrealized			Fair	Number of	Unrealized			Fair
Securities available-for-sale	Securities	Losses			Value	Securities	Losses			Value	Securities	Losses			Value
U.S. Treasuries	1	$	55	$	3,947	-	$	-	$	-	1	$	55	$	3,947
U.S. government agencies	2		9		6,550	-		-		-	2		9		6,550
U.S. government agencies mortgage-backed	4		24		5,501	5		141		4,843	9		165		10,344
States and political subdivisions	13		1,237		45,985	1		27		1,512	14		1,264		47,497
Corporate bonds	-		-		-	1		11		332	1		11		332
Collateralized mortgage obligations	3		31		11,534	8		1,124		40,219	11		1,155		51,753
Asset-backed securities	-		-		-	7		1,913		61,745	7		1,913		61,745
Collateralized loan obligations	3		101		29,313	-		-		-	3		101		29,313
Total securities available-for-sale	26	$	1,457	$	102,830	22	$	3,216	$	108,651	48	$	4,673	$	211,481

Recognition of other-than-temporary impairment was not necessary as of the three and nine months ended September 30, 2018. The changes in fair value related primarily to interest rate fluctuations. Our review of other-than-temporary impairment determined that there was no credit quality deterioration.

The following table presents net realized gains (losses) on securities available-for-sale for the three and nine months ended September 30, 2018 and 2017.


		Three Months Ended				Nine Months Ended
		September 30,				September 30,
Securities available-for-sale	2018		2017		2018		2017
Proceeds from sales of securities	$	1,917	$	51,620	$	94,663	$	152,476
Gross realized gains on securities		23		474		370		911
Gross realized losses on securities		(10)		(371)		(10)		(1,076)
Securities realized gains (losses), net	$	13	$	103	$	360	$	(165)
Income tax (expense) benefit on net realized gains (losses)		(2)		(42)		(100)		24

The majority of the net realized losses in the prior year were incurred as the portfolio was repositioned during 2017 to invest in higher yielding tax exempt municipal securities.

Securities valued at $311.2 million as of September 30, 2018, an increase from $301.0 million at year-end 2017, were pledged to secure deposits and borrowings, and for other purposes.

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Note 4 – Loans

Major classifications of loans were as follows:


	September 30, 2018		December 31, 2017
Commercial	$	306,407	$	272,851
Leases		70,661		68,325
Real estate - commercial		804,184		750,991
Real estate - construction		112,873		85,162
Real estate - residential		393,598		313,397
Home equity lines of credit "HELOC"		122,022		112,833
Other 1		12,969		13,383
Total loans, excluding deferred loan costs and PCI loans		1,822,714		1,616,942
Net deferred loan costs		1,348		680
Total loans, excluding PCI loans		1,824,062		1,617,622
PCI loans, net of purchase accounting adjustments		10,887		-
Total loans	$	1,834,949	$	1,617,622

1 The “Other” class includes consumer and overdrafts.

It is the policy of the Company to review each prospective credit prior to making a loan in order to determine if an adequate level of security or collateral has been obtained. The type of collateral, when required, will vary from liquid assets to real estate. The Company’s access to collateral, in the event of borrower default, is assured through adherence to lending laws, the Company’s lending standards and credit monitoring procedures. With selected exceptions, the Bank makes loans solely within its market area. There are no significant concentrations of loans where the customers’ ability to honor loan terms is dependent upon a single economic sector, although the real estate related categories listed above represent 78.1% and 78.0% of the portfolio at September 30, 2018, and December 31, 2017, respectively.

Aged analysis of past due loans by class of loans was as follows:


															Recorded
															Investment
															90 days or
					90 Days or										Greater Past
	30-59 Days		60-89 Days		Greater Past		Total Past								Due and
September 30, 2018	Past Due		Past Due		Due		Due		Current		Nonaccrual		Total Loans		Accruing
Commercial	$	1,074	$	-	$	6	$	1,080	$	305,327	$	-	$	306,407	$	6
Leases		-		-		-		-		70,661		-		70,661		-
Real estate - commercial
Owner occupied general purpose		1,022		-		-		1,022		164,304		1,625		166,951		-
Owner occupied special purpose		891		-		-		891		188,984		410		190,285		-
Non-owner occupied general purpose		346		3,422		-		3,768		293,979		142		297,889		-
Non-owner occupied special purpose		-		-		-		-		85,171		3,099		88,270		-
Retail properties		624		-		-		624		46,252		-		46,876		-
Farm		1,241		-		-		1,241		12,672		-		13,913		-
Real estate - construction
Homebuilder		-		-		-		-		4,556		-		4,556		-
Land		-		-		-		-		3,841		-		3,841		-
Commercial speculative		-		-		-		-		56,052		-		56,052		-
All other		38		-		-		38		48,277		109		48,424		-
Real estate - residential
Investor		952		-		-		952		70,102		364		71,418		-
Multifamily		1,304		-		73		1,377		179,645		-		181,022		76
Owner occupied		780		136		-		916		136,678		3,564		141,158		-
HELOC		1,422		92		-		1,514		119,880		628		122,022		-
Other 1		42		1		-		43		14,234		40		14,317		-
Total, excluding PCI loans	$	9,736	$	3,651	$	79	$	13,466	$	1,800,615	$	9,981	$	1,824,062	$	82
PCI loans, net of purchase accounting adjustments		3,415		-		-		3,415		5,174		2,298		10,887		-
Total	$	13,151	$	3,651	$	79	$	16,881	$	1,805,789	$	12,279	$	1,834,949	$	82

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)


															Recorded
															Investment
															90 days or
					90 Days or										Greater Past
	30-59 Days		60-89 Days		Greater Past		Total Past								Due and
December 31, 2017	Past Due		Past Due		Due		Due		Current		Nonaccrual		Total Loans		Accruing
Commercial	$	995	$	275	$	-	$	1,270	$	271,581	$	-	$	272,851	$	-
Leases		-		-		-		-		68,147		178		68,325		-
Real estate - commercial
Owner occupied general purpose		1,136		-		-		1,136		144,267		455		145,858		-
Owner occupied special purpose		226		-		-		226		170,546		342		171,114		-
Non-owner occupied general purpose		-		593		-		593		273,203		1,163		274,959		-
Non-owner occupied special purpose		-		-		248		248		92,923		-		93,171		254
Retail properties		-		-		-		-		49,538		1,081		50,619		-
Farm		-		-		-		-		15,270		-		15,270		-
Real estate - construction
Homebuilder		129		-		-		129		2,221		-		2,350		-
Land		1,124		-		-		1,124		1,319		-		2,443		-
Commercial speculative		-		-		-		-		32,028		-		32,028		-
All other		-		-		-		-		48,140		201		48,341		-
Real estate - residential
Investor		-		-		-		-		55,248		372		55,620		-
Multifamily		-		-		-		-		125,049		4,723		129,772		-
Owner occupied		74		-		-		74		123,257		4,674		128,005		-
HELOC		491		278		-		769		110,872		1,192		112,833		-
Other 1		37		-		-		37		14,019		7		14,063		-
Total	$	4,212	$	1,146	$	248	$	5,606	$	1,597,628	$	14,388	$	1,617,622	$	254

1 The “Other” class includes consumer, overdrafts and net deferred costs.

Credit Quality Indicators

The Company categorizes loans into credit risk categories based on current financial information, overall debt service coverage, comparison against industry averages, historical payment experience, and current economic trends. This analysis includes loans with outstanding balances or commitments greater than $50,000 and excludes homogeneous loans such as home equity lines of credit and residential mortgages. Loans with a classified risk rating are reviewed quarterly regardless of size or loan type. The Company uses the following definitions for classified risk ratings:

Special Mention. Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan at some future date.

Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.

Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

Credits that are not covered by the definitions above are pass credits, which are not considered to be adversely rated.

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Credit Quality Indicators by class of loans were as follows:


September 30, 2018			Special
	Pass		Mention		Substandard 2		Doubtful		Total
Commercial	$	303,176	$	2,878	$	353	$	-	$	306,407
Leases		70,661		-		-		-		70,661
Real estate - commercial
Owner occupied general purpose		160,999		1,489		4,463		-		166,951
Owner occupied special purpose		183,375		2,883		4,027		-		190,285
Non-owner occupied general purpose		289,438		834		7,617		-		297,889
Non-owner occupied special purpose		83,648		1,523		3,099		-		88,270
Retail Properties		45,074		-		1,802		-		46,876
Farm		11,423		1,249		1,241		-		13,913
Real estate - construction
Homebuilder		4,556		-		-		-		4,556
Land		3,841		-		-		-		3,841
Commercial speculative		56,052		-		-		-		56,052
All other		46,152		1,990		282		-		48,424
Real estate - residential
Investor		70,315		-		1,103		-		71,418
Multifamily		177,845		-		3,177		-		181,022
Owner occupied		135,625		511		5,022		-		141,158
HELOC		120,193		-		1,829		-		122,022
Other 1		14,262		-		55		-		14,317
Total, excluding PCI loans	$	1,776,635	$	13,357	$	34,070	$	-	$	1,824,062
PCI loans, net of purchase accounting adjustments		-		-		10,887		-		10,887
Total	$	1,776,635	$	13,357	$	44,957	$	-	$	1,834,949


December 31, 2017			Special
	Pass		Mention		Substandard 2		Doubtful		Total
Commercial	$	270,889	$	1,962	$	-	$	-	$	272,851
Leases		67,500		-		825		-		68,325
Real estate - commercial
Owner occupied general purpose		142,843		1,927		1,088		-		145,858
Owner occupied special purpose		169,621		1,152		341		-		171,114
Non-owner occupied general purpose		271,731		2,065		1,163		-		274,959
Non-owner occupied special purpose		89,582		-		3,589		-		93,171
Retail Properties		48,321		1,217		1,081		-		50,619
Farm		11,755		1,029		2,486		-		15,270
Real estate - construction
Homebuilder		2,350		-		-		-		2,350
Land		2,443		-		-		-		2,443
Commercial speculative		32,028		-		-		-		32,028
All other		46,913		1,052		376		-		48,341
Real estate - residential
Investor		55,172		-		448		-		55,620
Multifamily		125,049		-		4,723		-		129,772
Owner occupied		122,178		561		5,266		-		128,005
HELOC		110,934		-		1,899		-		112,833
Other 1		14,043		-		20		-		14,063
Total	$	1,583,352	$	10,965	$	23,305	$	-	$	1,617,622

1 The “Other” class includes consumer, overdrafts and net deferred costs.

2 The substandard credit quality indicator includes both potential problem loans that are currently performing and nonperforming loans.

The Company had $1.0 million and $1.3 million in residential real estate loans in the process of foreclosure as of September 30, 2018, and December 31, 2017, respectively.

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

The following tables set forth the recorded investments, unpaid principal balance and related allowance, excluding purchased credit-impaired loans, by class of loans for the three and nine months ended September 30, 2018:


							Three Months Ended				Nine Months Ended
	As of September 30, 2018						September 30, 2018				September 30, 2018
			Unpaid				Average		Interest		Average		Interest
	Recorded		Principal		Related		Recorded		Income		Recorded		Income
	Investment		Balance		Allowance		Investment		Recognized		Investment		Recognized
With no related allowance recorded
Commercial	$	-	$	-	$	-	$	-	$	-	$	-	$	-
Leases		-		-		-		-		-		-		-
Commercial real estate
Owner occupied general purpose		1,614		1,699		-		1,263		2		1,035		5
Owner occupied special purpose		409		538		-		417		-		375		-
Non-owner occupied general purpose		142		158		-		91		-		653		-
Non-owner occupied special purpose		-		-		-		-		-		-		-
Retail properties		-		-		-		-		-		-		-
Farm		-		-		-		-		-		-		-
Construction
Homebuilder		-		-		-		-		-		-		-
Land		-		-		-		-		-		-		-
Commercial speculative		-		-		-		-		-		-		-
All other		50		74		-		121		-		125		-
Residential
Investor		365		466		-		368		-		369		-
Multifamily		-		-		-		-		-		2,361		-
Owner occupied		3,855		5,326		-		4,050		11		4,532		29
HELOC		634		739		-		687		-		880		1
Other 1		14		15		-		15		-		10		-
Total impaired loans with no recorded allowance		7,083		9,015		-		7,012		13		10,340		35

With an allowance recorded
Commercial		-		-		-		-		-		-		-
Leases		-		-		-		-		-		-		-
Commercial real estate
Owner occupied general purpose		518		518		46		259		22		259		22
Owner occupied special purpose		-		-		-		-		-		-		-
Non-owner occupied general purpose		-		-		-		-		-		-		-
Non-owner occupied special purpose		3,099		3,575		139		3,099		-		1,550		-
Retail properties		-		-		-		-		-		-		-
Farm		-		-		-		-		-		-		-
Construction
Homebuilder		-		-		-		-		-		-		-
Land		-		-		-		-		-		-		-
Commercial speculative		-		-		-		-		-		-		-
All other		59		59		42		30		-		29		-
Residential
Investor		810		810		10		812		11		820		33
Multifamily		-		-		-		-		-		-		-
Owner occupied		3,710		3,710		49		3,678		35		3,576		108
HELOC		1,420		1,420		61		1,371		17		1,203		41
Other 1		26		26		26		14		-		13		-
Total impaired loans with a recorded allowance		9,642		10,118		373		9,263		85		7,450		204
Total impaired loans	$	16,725	$	19,133	$	373	$	16,275	$	98	$	17,790	$	239

1 The “Other” class includes consumer, overdrafts and net deferred costs.

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Impaired loans by class of loans as of December 31, 2017, and for the three and nine months ended September 30, 2017, were as follows:


							Three Months Ended				Nine Months Ended
	As of December 31, 2017						September 30, 2017				September 30, 2017
			Unpaid				Average		Interest		Average		Interest
	Recorded		Principal		Related		Recorded		Income		Recorded		Income
	Investment		Balance		Allowance		Investment		Recognized		Investment		Recognized
With no related allowance recorded
Commercial	$	-	$	-	$	-	$	212	$	-	$	123	$	-
Leases		178		213		-		208		-		281		-
Commercial real estate
Owner occupied general purpose		455		495		-		458		-		1,169		-
Owner occupied special purpose		342		498		-		363		-		372		-
Non-owner occupied general purpose		1,163		1,538		-		1,180		1		1,481		2
Non-owner occupied special purpose		-		-		-		-		-		507		-
Retail properties		1,081		1,177		-		1,129		-		1,146		-
Farm		-		-		-		-		-		-		-
Construction
Homebuilder		-		-		-		-		-		-		-
Land		-		-		-		-		-		-		-
Commercial speculative		-		-		-		34		-		37		-
All other		201		229		-		178		-		206		-
Residential
Investor		372		676		-		1,475		16		1,607		36
Multifamily		4,723		4,965		-		4,791		-		2,379		-
Owner occupied		5,208		6,680		-		8,179		54		8,987		119
HELOC		1,125		1,313		-		1,981		12		2,237		27
Other 1		7		8		-		9		-		104		-
Total impaired loans with no recorded allowance		14,855		17,792		-		20,197		83		20,636		184

With an allowance recorded
Commercial		-		-		-		-		-		-		-
Leases		-		-		-		120		-		-		-
Commercial real estate
Owner occupied general purpose		-		-		-		-		-		-		-
Owner occupied special purpose		-		-		-		-		-		-		-
Non-owner occupied general purpose		-		-		-		-		-		123		-
Non-owner occupied special purpose		-		-		-		-		-		-		-
Retail properties		-		-		-		-		-		-		-
Farm		-		-		-		-		-		-		-
Construction
Homebuilder		-		-		-		-		-		-		-
Land		-		-		-		-		-		-		-
Commercial speculative		-		-		-		-		-		-		-
All other		-		-		-		-		-		-		-
Residential
Investor		829		829		10		-		-		-		-
Multifamily		-		-		-		-		-		-		-
Owner occupied		3,443		3,443		43		-		-		402		-
HELOC		985		985		91		25		2		26		2
Other 1		-		-		-		-		-		-		-
Total impaired loans with a recorded allowance		5,257		5,257		144		145		2		551		2
Total impaired loans	$	20,112	$	23,049	$	144	$	20,342	$	85	$	21,187	$	186

1 The “Other” class includes consumer, overdrafts and net deferred costs.

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Troubled debt restructurings (“TDRs”) are loans for which the contractual terms have been modified and both of these conditions exist: (1) there is a concession to the borrower and (2) the borrower is experiencing financial difficulties. Loans are restructured on a case-by-case basis during the loan collection process with modifications generally initiated at the request of the borrower. These modifications may include reduction in interest rates, extension of term, deferrals of principal, and other modifications. The Bank participates in the U.S. Department of the Treasury’s (the “Treasury”) Home Affordable Modification Program (“HAMP”) which gives qualifying homeowners an opportunity to refinance into more affordable monthly payments.

The specific allocation of the allowance for loan and lease losses for TDRs is determined by calculating the present value of the TDR cash flows by discounting the original payment less an assumption for probability of default at the original note’s issue rate, and adding this amount to the present value of collateral less selling costs. If the resulting amount is less than the recorded book value, the Bank either establishes a valuation allowance (i.e., specific reserve) as a component of the allowance for loan and lease losses or charges off the impaired balance if it determines that such amount is a confirmed loss. This method is used consistently for all segments of the portfolio. The allowance for loan and lease losses also includes an allowance based on a loss migration analysis for each loan category on loans and leases that are not individually evaluated for specific impairment. All loans charged-off, including TDRs charged-off, are factored into this calculation by portfolio segment.

TDRs that were modified during the period are as follows:


	TDR Modifications					TDR Modifications
	Three Months Ended September 30, 2018					Nine Months Ended September 30, 2018
	# of	Pre-modification		Post-modification		# of	Pre-modification		Post-modification
	contracts	recorded investment		recorded investment		contracts	recorded investment		recorded investment
Troubled debt restructurings
Real estate - commercial
Owner occupied general purpose
Other1	1	$	427	$	424	1	$	427	$	424
Owner occupied special purpose
Other1	-		-		-	1		110		52
Real estate - residential
Owner occupied
HAMP2	1		211		211	3		383		331
Other1	1		34		29	1		34		29
HELOC
HAMP2	1		26		26	1		26		26
Rate3						1		24		24
Other1	2		93		92	9		596		587
Total	6	$	791	$	782	17	$	1,600	$	1,473


	TDR Modifications					TDR Modifications
	Three Months Ended September 30, 2017					Nine Months Ended September 30, 2017
	# of	Pre-modification		Post-modification		# of	Pre-modification		Post-modification
	contracts	recorded investment		recorded investment		contracts	recorded investment		recorded investment
Troubled debt restructurings
HELOC
Other1	2	$	155	$	147	6	$	399	$	388
Total	2	$	155	$	147	6	$	399	$	388

1 Other: Change of terms from bankruptcy court.

2 HAMP: Home Affordable Modification Program.

3 Rate: Refers to interest rate reduction.

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

TDRs are classified as being in default on a case-by-case basis when they fail to be in compliance with the modified terms. There was no TDR default activity for the periods ended September 30, 2018 and September 30, 2017, for loans that were restructured within the 12 month period prior to default.

The following table details the accretable discount on all of the Company’s purchased loans, both non-PCI loans and PCI loans as of September 30, 2018.


	Accretable Discount - Non-PCI Loans		Accretable Discount - PCI Loans		Non-Accretable Discount - PCI Loans		Total
Beginning balance, July 1, 2018	$	2,995	$	1,373	$	6,403	$	10,771
Purchases		-		-		-		-
Accretion		(312)		(129)		(334)		(775)
Transfer1		(373)		(26)		-		(399)
Ending balance, September 30, 2018	$	2,310	$	1,218	$	6,069	$	9,597

1 Transfer was due to loans moved to OREO.

Note 5 – Allowance for Loan and Lease Losses

Changes in the allowance for loan and lease losses by segment of loans based on method of impairment for the three and nine months ended September 30, 2018, were as follows:


					Real Estate		Real Estate		Real Estate
Allowance for loan and lease losses:	Commercial		Leases		Commercial		Construction		Residential		HELOC		Other1		Total
Three months ended September 30, 2018
Beginning balance	$	2,676	$	634	$	10,537	$	1,398	$	1,818	$	1,390	$	868	$	19,321
Charge-offs		7		-		201		-		-		49		115		372
Recoveries		32		-		37		32		83		139		56		379
Provision (Release)		96		31		(144)		(374)		67		(372)		696		-
Ending balance	$	2,797	$	665	$	10,229	$	1,056	$	1,968	$	1,108	$	1,505	$	19,328

Nine months ended September 30, 2018
Beginning balance	$	2,453	$	692	$	9,522	$	923	$	1,846	$	1,446	$	579	$	17,461
Charge-offs		38		13		609		(16)		(55)		141		316		1,046
Recoveries		141		-		425		35		1,099		277		208		2,185
Provision (Release)		241		(14)		891		82		(1,032)		(474)		1,034		728
Ending balance	$	2,797	$	665	$	10,229	$	1,056	$	1,968	$	1,108	$	1,505	$	19,328

Ending balance: Individually evaluated for impairment	$	-	$	-	$	185	$	42	$	59	$	61	$	26	$	373
Ending balance: Collectively evaluated for impairment		2,797		665		10,044		1,014		1,909		1,047		1,479		18,955
Ending balance: Acquired and accounted for ASC 310-30		-		-		-		-		-		-		-		-
Total ending allowance balance	$	2,797	$	665	$	10,229	$	1,056	$	1,968	$	1,108	$	1,505	$	19,328

Loans:
Ending balance: Individually evaluated for Impairment	$	-	$	-	$	5,782	$	109	$	8,740	$	2,054	$	40	$	16,725
Ending balance: Collectively evaluated for impairment		306,407		70,661		798,402		112,764		384,858		119,968		14,277		1,807,337
Ending balance: Acquired and accounted for ASC 310-30		-		-		4,126		778		5,983		-		-		10,887
Total ending loans balance	$	306,407	$	70,661	$	808,310	$	113,651	$	399,581	$	122,022	$	14,317	$	1,834,949

1 The “Other” class includes consumer, overdrafts and net deferred costs.

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Changes in the allowance for loan and lease losses by segment of loans based on method of impairment for the three and nine months ended September 30, 2017, were as follows:


Allowance for loan and lease losses:	Commercial		Leases		Commercial		Construction		Residential		HELOC		Other1		Total
Three months ended September 30, 2017
Beginning balance	$	2,150	$	791	$	8,107	$	857	$	1,872	$	1,513	$	546	$	15,836
Charge-offs		13		98		22		19		5		2		82		241
Recoveries		6		-		43		11		90		369		51		570
(Release) Provision		(104)		77		505		165		(187)		(455)		299		300
Ending balance	$	2,039	$	770	$	8,633	$	1,014	$	1,770	$	1,425	$	814	$	16,465

Nine months ended September 30, 2017
Beginning balance	$	1,629	$	633	$	9,547	$	389	$	2,178	$	1,331	$	451	$	16,158
Charge-offs		20		215		300		23		982		196		262		1,998
Recoveries		13		-		124		89		243		607		179		1,255
Provision (Release)		417		352		(738)		559		331		(317)		446		1,050
Ending balance	$	2,039	$	770	$	8,633	$	1,014	$	1,770	$	1,425	$	814	$	16,465

Ending balance: Individually evaluated for impairment	$	-	$	-	$	-	$	-	$	6	$	-	$	-	$	6
Ending balance: Collectively evaluated for impairment		2,039		770		8,633		1,014		1,764		1,425		814		16,459
Total ending allowance balance	$	2,039	$	770	$	8,633	$	1,014	$	1,770	$	1,425	$	814	$	16,465

Loans:
Ending balance: Individually evaluated for impairment	$	207	$	196	$	3,147	$	205	$	14,281	$	2,042	$	8	$	20,086
Ending balance: Collectively evaluated for impairment		257,149		69,109		735,989		94,663		288,799		114,461		13,935		1,574,105
Total ending loan balance	$	257,356	$	69,305	$	739,136	$	94,868	$	303,080	$	116,503	$	13,943	$	1,594,191

1 The “Other” class includes consumer, overdrafts and net deferred costs.

Note 6 – Other Real Estate Owned

Details related to the activity in the other real estate owned (“OREO”) portfolio, net of valuation reserve, for the periods presented are itemized in the following table:


	Three Months Ended				Nine Months Ended
	September 30,				September 30,
Other real estate owned	2018		2017		2018		2017
Balance at beginning of period	$	8,912	$	11,724	$	8,371	$	11,916
Property additions, net of acquisition adjustments		(217)		176		2,595		3,796
Property improvements		-		-		59		-
Less:
Proceeds from property disposals, net of participation purchase and of gains/losses		1,612		1,956		3,576		5,058
Period valuation adjustments		119		920		485		1,630
Balance at end of period	$	6,964	$	9,024	$	6,964	$	9,024

Activity in the valuation allowance was as follows:


	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2018		2017		2018		2017
Balance at beginning of period	$	8,348	$	8,304	$	8,208	$	9,982
Provision for unrealized losses		119		920		485		1,630
Reductions taken on sales		(456)		(421)		(682)		(2,809)
Other adjustments		-		-		-		-
Balance at end of period	$	8,011	$	8,803	$	8,011	$	8,803

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Expenses related to OREO, net of lease revenue includes:


	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2018		2017		2018		2017
Gain on sales, net	$	(612)	$	(276)	$	(716)	$	(454)
Provision for unrealized losses		119		920		485		1,630
Operating expenses		133		221		502		1,037
Less:
Lease revenue		10		185		39		285
Net OREO expense	$	(370)	$	680	$	232	$	1,928

Note 7 – Deposits

Major classifications of deposits were as follows:


	September 30, 2018		December 31, 2017
Noninterest bearing demand	$	621,580	$	572,404
Savings		298,073		262,220
NOW accounts		437,361		429,448
Money market accounts		310,452		276,082
Certificates of deposit of less than $100,000		235,272		216,493
Certificates of deposit of $100,000 through $250,000		163,716		122,489
Certificates of deposit of more than $250,000		65,916		43,789
Total deposits	$	2,132,370	$	1,922,925

Note 8 – Borrowings

The following table is a summary of borrowings as of September 30, 2018, and December 31, 2017. Junior subordinated debentures are discussed in detail in Note 9:


	September 30, 2018		December 31, 2017
Securities sold under repurchase agreements	$	44,333	$	29,918
Other short-term borrowings 1		81,875		115,000
Junior subordinated debentures		57,674		57,639
Senior notes		44,133		44,058
Notes payable and other borrowings		18,050		-
Total borrowings	$	246,065	$	246,615

1 Includes short-term FHLBC advances and the outstanding portion of an operating line of credit.

The Company enters into deposit sweep transactions where the transaction amounts are secured by pledged securities. These transactions consistently mature overnight from the transaction date and are governed by sweep repurchase agreements. All sweep repurchase agreements are treated as financings secured by U.S. government agencies and collateralized mortgage-backed securities and had a carrying amount of $44.3 million at September 30, 2018, and $29.9 million at December 31, 2017. The fair value of the pledged collateral was $72.6 million at September 30, 2018 and $40.0 million at December 31, 2017. At September 30, 2018, there were no customers with secured balances exceeding 10% of stockholders’ equity.

The Company’s borrowings at the FHLBC require the Bank to be a member and invest in the stock of the FHLBC. Total borrowings are generally limited to the lower of 35% of total assets or 60% of the book value of certain mortgage loans. As of September 30, 2018, the Bank had $77.9 million in short-term advances outstanding under the FHLBC compared to $115.0 million outstanding as of December 31, 2017; $65.0 million of the September 30, 2018, balance was issued at 2.22%, and $5.0 million was issued at 2.24%. The additional $4.0 million in other short-term borrowings as of September 30, 2018, was the outstanding portion of a $20.0 million line of credit the Company has with a correspondent bank for short-term funding needs, paying 3.85% as of the current quarter end; advances under the line can be outstanding up to 360 days from date of issuance. The Bank also assumed $23.5 million of long-term FHLBC advances with the ABC Bank acquisition. At September 30, 2018, these advances have a total outstanding balance

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

of $18.1 million and are scheduled to mature over the next 7.5 years with interest rates ranging between 1.40% to 2.83 %. FHLBC stock held was valued at $4.3 million, and any potential FHLBC advances were collateralized by securities with a fair value of $77.3 million and loans with a principal balance of $304.2 million, which carried a FHLBC calculated combined collateral value of $303.3 million. The Company had excess collateral of $133.0 million available to secure borrowings at September 30, 2018.

The Company also has $44.1 million of senior notes outstanding, net of deferred issuance costs, as of September 30, 2018 and December 31, 2017. The senior notes mature in ten years, and terms include interest payable semiannually at 5.75% for five years. Beginning December 2021, the senior debt will pay interest at a floating rate, with interest payable quarterly at three month LIBOR plus 385 basis points. The notes are redeemable, in whole or in part, at the option of the Company, beginning with the interest payment date on December 31, 2021, and on any floating rate interest payment date thereafter, at a redemption price equal to 100% of the principal amount of the notes plus accrued and unpaid interest. As of September 30, 2018 and December 31, 2017, unamortized debt issuance costs related to the senior notes were $867,000 and $942,000, respectively, and are included as a reduction of the balance of the senior notes on the Consolidated Balance Sheet. These deferred issuance costs will be amortized to interest expense over the ten year term of the notes and are included in the Consolidated Statements of Income.

Note 9 – Junior Subordinated Debentures

The Company completed the sale of $27.5 million of cumulative trust preferred securities by its unconsolidated subsidiary, Old Second Capital Trust I, in June 2003. An additional $4.1 million of cumulative trust preferred securities were sold in July 2003. The trust preferred securities may remain outstanding for a 30-year term but, subject to regulatory approval, can be called in whole or in part by the Company after June 30, 2008. When not in deferral, distributions on the securities are payable quarterly at an annual rate of 7.80%. The Company issued a new $32.6 million subordinated debenture to Old Second Capital Trust I in return for the aggregate net proceeds of this trust preferred offering. The interest rate and payment frequency on the debenture are equivalent to the cash distribution basis on the trust preferred securities.

The Company issued an additional $25.0 million of cumulative trust preferred securities through a private placement completed by an additional, unconsolidated subsidiary, Old Second Capital Trust II, in April 2007. These trust preferred securities also mature in 30 years, but subject to the aforementioned regulatory approval, can be called in whole or in part on a quarterly basis commencing June 15, 2017. The quarterly cash distributions on the securities were fixed at 6.77% through June 15, 2017, and float at 150 basis points over three-month LIBOR thereafter. Upon conversion to a floating rate, a cash flow hedge was initiated which resulted in the total interest rate paid on the debt of 4.34% as of September 30, 2018, compared to the rate paid prior to June 15, 2017 of 6.77%. The Company issued a new $25.8 million subordinated debenture to Old Second Capital Trust II in return for the aggregate net proceeds of this trust preferred offering. The interest rate and payment frequency on the debenture are equivalent to the cash distribution basis on the trust preferred securities.

Both of the debentures issued by the Company are disclosed on the Consolidated Balance Sheet as junior subordinated debentures and the related interest expense for each issuance is included in the Consolidated Statements of Income. As of September 30, 2018, and December 31, 2017, unamortized debt issuance costs related to the junior subordinated debentures were $704,000 and $739,000 respectively, and are included as a reduction to the balance of the junior subordinated debentures on the Consolidated Balance Sheet. These deferred issuance costs will be amortized to interest expense over the 30-year term of the notes and are included in the Consolidated Statements of Income.

Note 10 – Equity Compensation Plans

Stock-based awards are outstanding under the Company’s 2008 Equity Incentive Plan (the “2008 Plan”) and the Company’s 2014 Equity Incentive Plan, as amended (the “2014 Plan,” and together with the 2008 Plan, the “Plans”). The 2014 Plan was approved at the 2014 annual meeting of stockholders; a maximum of 375,000 shares were authorized to be issued under this plan. Following approval of the 2014 Plan, no further awards will be granted under the 2008 Plan or any other Company equity compensation plan. At the May 2016 annual stockholders meeting, an amendment to the 2014 Plan authorized an additional 600,000 shares to be issued, which resulted in a total of 975,000 shares authorized for issuance under this plan. The 2014 Plan authorizes the granting of qualified stock options, non-qualified stock options, restricted stock, restricted stock units, and stock appreciation rights. Awards may be granted to selected directors and officers or employees under the 2014 Plan at the discretion of the Compensation Committee of the Company’s Board of Directors. As of September 30, 2018, 169,791 shares remained available for issuance under the 2014 Plan.

There were no stock options granted or exercised in the nine months ended September 30, 2018 and 2017. All stock options are granted for a term of ten years. There is no unrecognized compensation cost related to unvested stock options as all stock options of the Company’s common stock have fully vested.

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

A summary of stock option activity in the Plans for the nine months ended September 30, 2018, is as follows:


				Weighted-
		Weighted		Average
		Average		Remaining
		Exercise		Contractual	Aggregate
	Shares	Price		Term (years)	Intrinsic Value
Beginning outstanding	9,000	$	7.49	-		-
Canceled	-		-	-		-
Expired	-		-	-		-
Ending outstanding	9,000	$	7.49	0.4	$	72

Exercisable at end of period	9,000	$	7.49	0.4	$	72

Generally, restricted stock and restricted stock units granted under the Plans vest three years from the grant date, but the Compensation Committee of the Company’s Board of Directors has discretionary authority to change some terms including the amount of time until the vest date.

Awards under the 2008 Plan will become fully vested upon a merger or change in control of the Company. Under the 2014 Plan, upon a change in control of the Company, if (i) the 2014 Plan is not an obligation of the successor entity following the change in control, or (ii) the 2014 Plan is an obligation of the successor entity following the change in control and the participant incurs an involuntary termination, then the stock options, stock appreciation rights, stock awards and cash incentive awards under the 2014 Plan will become fully exercisable and vested. Performance-based awards generally will vest based upon the level of achievement of the applicable performance measures through the change in control.

The Company granted restricted stock under its equity compensation plans beginning in 2005 and it began granting restricted stock units in February 2009. Awards of restricted stock under the Plans generally entitle holders to voting and dividend rights upon grant and are subject to forfeiture until certain restrictions have lapsed including employment for a specific period. Awards of restricted stock units under the Plans are also subject to forfeiture until certain restrictions have lapsed including employment for a specific period, but do not entitle holders to voting rights until the restricted period ends and shares are transferred in connection with the units.

There were 254,281 restricted stock units issued under the 2014 Plan during the nine months ended September 30, 2018, which included 140,000 units granted under a new performance restricted stock unit agreement for select officers and all directors. The performance period covers January 1, 2018 through December 31, 2020, and vesting will be based upon the achievement of certain key Company performance metrics, such as total shareholder returns, earnings, and corporate efficiencies. There were 161,500 restricted stock units issued during the nine months ended September 30, 2017. Compensation expense is recognized over the vesting period of the restricted stock unit based on the market value of the award on the issue date. Total compensation cost that has been recorded for the 2014 Plan was $1.7 million and $925,000 in the first nine months of 2018 and 2017, respectively.

A summary of changes in the Company’s unvested restricted awards for the nine months ended September 30, 2018, is as follows:


	September 30, 2018
		Weighted
	Restricted	Average
	Stock Shares	Grant Date
	and Units	Fair Value
Unvested at January 1	465,000	$	7.79
Granted	254,281		13.98
Vested	(155,500)		5.14
Forfeited	-		-
Unvested at September 30	563,781	$	11.31

Total unrecognized compensation cost of restricted awards was $3.6 million as of September 30, 2018, which is expected to be recognized over a weighted-average period of 2.01 years.

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Note 11 – Earnings Per Share

The earnings per share – both basic and diluted – are included below as of September 30 (in thousands except for share and per share data):


	Three Months Ended September 30,				Nine Months Ended September 30,
	2018		2017		2018		2017
Basic earnings per share:
Weighted-average common shares outstanding		29,747,078		29,627,086		29,718,191		29,591,811
Net income	$	9,642	$	8,077	$	25,392	$	17,650
Basic earnings per share	$	0.32	$	0.27	$	0.85	$	0.60
Diluted earnings per share:
Weighted-average common shares outstanding		29,747,078		29,627,086		29,718,191		29,591,811
Dilutive effect of unvested restricted awards1		563,781		473,967		525,627		425,081
Dilutive effect of stock options and warrants		73,032		2,556		53,476		2,473
Diluted average common shares outstanding		30,383,891		30,103,609		30,297,294		30,019,365
Net Income	$	9,642	$	8,077	$	25,392	$	17,650
Diluted earnings per share	$	0.32	$	0.27	$	0.84	$	0.59

Number of antidilutive options and warrants excluded from the diluted earnings per share calculation		-		900,839		-		900,839

1 Includes the common stock equivalents for restricted share rights that are dilutive.

The above earnings per share calculation also includes a warrant for 815,339 shares of common stock, at an exercise price of $13.43 per share, that was outstanding as of September 30, 2018, and is considered dilutive. The same warrant was not included as of September 30, 2017, because the warrant was anti-dilutive. The ten-year warrant was issued in 2009, and was sold at auction by the U.S. Treasury in June 2013 to a third party investor.

Note 12 – Regulatory & Capital Matters

The Bank is subject to the risk-based capital regulatory guidelines, which include the methodology for calculating the risk-weighted Bank assets, developed by the Office of the Comptroller of the Currency (the “OCC”) and the other bank regulatory agencies. In connection with the current economic environment, the Bank’s current level of nonperforming assets and the risk-based capital guidelines, the Bank’s Board of Directors has determined that the Bank should maintain a Tier 1 leverage capital ratio at or above eight percent (8%) and a total risk-based capital ratio at or above twelve percent (12%). At September 30, 2018, the Bank exceeded those thresholds.

At September 30, 2018, the Bank’s Tier 1 capital leverage ratio was 11.05%, an increase of 26 basis points from December 31, 2017, and is well above the 8.00% objective. The Bank’s total capital ratio was 14.16%, an increase of 38 basis points from December 31, 2017, and also well above the objective of 12.00%.

Bank holding companies are required to maintain minimum levels of capital in accordance with capital guidelines implemented by the Board of Governors of the Federal Reserve System. The general bank and holding company capital adequacy guidelines are shown in the accompanying table, as are the capital ratios of the Company and the Bank, as of September 30, 2018 and December 31, 2017.

In July 2013, the U.S. federal banking authorities issued final rules (the “Basel III Rules”) establishing more stringent regulatory capital requirements for U.S. banking institutions, which went into effect on January 1, 2015. A detailed discussion of the Basel III Rules is included in Part I, Item 1 of the Company’s Form 10-K for the year ended December 31, 2017, under the heading “Supervision and Regulation.”

At September 30, 2018, and December 31, 2017, the Company, on a consolidated basis, exceeded the minimum thresholds to be considered “well capitalized” under current regulatory defined capital ratios.

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Capital levels and industry defined regulatory minimum required levels are as follows:


					Minimum Capital				To Be Well Capitalized Under
					Adequacy with Capital				Prompt Corrective
	Actual				Conservation Buffer if applicable1				Action Provisions2
	Amount		Ratio		Amount		Ratio		Amount		Ratio
September 30, 2018
Common equity tier 1 capital to risk weighted assets
Consolidated	$	196,632	9.12	%	$	137,448	6.375	%		N/A	N/A
Old Second Bank		285,010	13.26			137,024	6.375		$	139,711	6.50	%
Total capital to risk weighted assets
Consolidated		270,976	12.57			212,879	9.875			N/A	N/A
Old Second Bank		304,333	14.16			212,238	9.875			214,924	10.00
Tier 1 capital to risk weighted assets
Consolidated		251,653	11.67			169,817	7.875			N/A	N/A
Old Second Bank		285,010	13.26			169,265	7.875			171,952	8.00
Tier 1 capital to average assets
Consolidated		251,653	9.72			103,561	4.00			N/A	N/A
Old Second Bank		285,010	11.05			103,171	4.00			128,964	5.00

December 31, 2017
Common equity tier 1 capital to risk weighted assets
Consolidated	$	179,853	9.25	%	$	111,801	5.750	%		N/A	N/A
Old Second Bank		249,417	12.88			111,347	5.750		$	125,870	6.50	%
Total capital to risk weighted assets
Consolidated		251,383	12.93			179,837	9.250			N/A	N/A
Old Second Bank		266,873	13.78			179,142	9.250			193,667	10.00
Tier 1 capital to risk weighted assets
Consolidated		233,927	12.03			140,978	7.250			N/A	N/A
Old Second Bank		249,417	12.88			140,394	7.250			154,917	8.00
Tier 1 capital to average assets
Consolidated		233,927	10.08			92,828	4.00			N/A	N/A
Old Second Bank		249,417	10.79			92,462	4.00			115,578	5.00

1 As of September 30, 2018, amounts are shown inclusive of a capital conservation buffer of 1.875%; as compared to December 31, 2017, of 1.25%.

2 The Bank exceeded the general minimum regulatory requirements to be considered “well capitalized.”

Dividend Restrictions

In addition to the above requirements, banking regulations and capital guidelines generally limit the amount of dividends that may be paid by a bank without prior regulatory approval. Under these regulations, the amount of dividends that may be paid in any calendar year is limited to the current year’s profits, combined with the retained profit of the previous two years, subject to the capital requirements described above. Pursuant to the Basel III rules that came into effect January 1, 2015, the Bank must keep a buffer of 0.625% for 2016, 1.25% for 2017, 1.875% for 2018, and 2.5% for 2019 and thereafter of minimum capital requirements in order to avoid additional limitations on capital distributions and certain other payments.

Note 13 – Fair Value Measurements

Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The fair value hierarchy established by the Company also requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Three levels of inputs that may be used to measure fair value are:

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the Company has the ability to access as of the measurement date.

Level 2: Significant observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.

Level 3: Significant unobservable inputs that reflect a company’s own view about the assumptions that market participants would use in pricing an asset or liability.

The majority of securities available-for-sale are valued by external pricing services or dealer market participants and are classified in Level 2 of the fair value hierarchy. Both market and income valuation approaches are utilized. Quarterly, the Company evaluates the methodologies used by the external pricing services or dealer market participants to develop the fair values to determine whether the results of the valuations are representative of an exit price in the Company’s principal markets and an appropriate representation of fair value. The Company uses the following methods and significant assumptions to estimate fair value:

Government-sponsored agency debt securities are primarily priced using available market information through processes such as benchmark spreads, market valuations of like securities, like securities groupings and matrix pricing.

Other government-sponsored agency securities, MBS and some of the actively traded real estate mortgage investment conduits and collateralized mortgage obligations are priced using available market information including benchmark yields, prepayment speeds, spreads, volatility of similar securities and trade date.

State and political subdivisions are largely grouped by characteristics (e.g., geographical data and source of revenue in trade dissemination systems). Because some securities are not traded daily and due to other grouping limitations, active market quotes are often obtained using benchmarking for like securities.

Auction rate securities are priced using market spreads, cash flows, prepayment speeds, and loss analytics. Therefore, the valuations of auction rate asset-backed securities are considered Level 2 valuations.

Asset-backed collateralized loan obligations were priced using data from a pricing matrix supported by our bond accounting service provider and are therefore considered Level 2 valuations.

Annually every security holding is priced by a pricing service independent of the regular and recurring pricing services used. The independent service provides a measurement to indicate if the price assigned by the regular service is within or outside of a reasonable range. Management reviews this report and applies judgment in adjusting calculations at year end related to securities pricing.

Residential mortgage loans available for sale in the secondary market are carried at fair market value. The fair value of loans held-for-sale is determined using quoted secondary market prices.

Lending related commitments to fund certain residential mortgage loans, e.g., residential mortgage loans with locked interest rates to be sold in the secondary market and forward commitments for the future delivery of mortgage loans to third party investors, as well as forward commitments for future delivery of MBS are considered derivatives. Fair values are estimated based on observable changes in mortgage interest rates including prices for MBS from the date of the commitment and do not typically involve significant judgments by management.

The fair value of mortgage servicing rights is based on a valuation model that calculates the present value of estimated net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income to derive the resultant value. The Company is able to compare the valuation model inputs, such as the discount rate, prepayment speeds, weighted average delinquency and foreclosure/bankruptcy rates to widely available published industry data for reasonableness.

Interest rate swap positions, both assets and liabilities, are based on valuation pricing models using an income approach reflecting readily observable market parameters such as interest rate yield curves.

The fair value of impaired loans with specific allocations of the allowance for loan and lease losses is essentially based on recent real estate appraisals or the fair value of the collateralized asset. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are made in the appraisal process by the appraisers to reflect differences between the available comparable sales and income data. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

Nonrecurring adjustments to certain commercial and residential real estate properties classified as OREO are measured at the lower of carrying amount or fair value, less costs to sell. Fair values are based on third party appraisals of the property, resulting in a Level 3 classification. In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized.

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Assets and Liabilities Measured at Fair Value on a Recurring Basis:

The tables below present the balance of assets and liabilities at September 30, 2018, and December 31, 2017, respectively, measured by the Company at fair value on a recurring basis:


	September 30, 2018
	Level 1		Level 2		Level 3		Total
Assets:
Securities available-for-sale
U.S. Treasury	$	3,854	$	-	$	-	$	3,854
U.S. government agencies		-		11,703		-		11,703
U.S. government agencies mortgage-backed		-		14,766		-		14,766
States and political subdivisions		-		262,753		9,511		272,264
Collateralized mortgage obligations		-		63,396		1,564		64,960
Asset-backed securities		-		109,173		-		109,173
Collateralized loan obligations		-		65,618		-		65,618
Loans held-for-sale		-		2,911		-		2,911
Mortgage servicing rights		-		-		8,131		8,131
Interest rate swap agreements		-		2,803		-		2,803
Mortgage banking derivatives		-		151		-		151
Total	$	3,854	$	533,274	$	19,206	$	556,334

Liabilities:
Interest rate swap agreements	$	-	$	2,803	$	-	$	2,803
Total	$	-	$	2,803	$	-	$	2,803


	December 31, 2017
	Level 1		Level 2		Level 3		Total
Assets:
Securities available-for-sale
U.S. Treasury	$	3,947	$	-	$	-	$	3,947
U.S. government agencies		-		13,061		-		13,061
U.S. government agencies mortgage-backed		-		12,214		-		12,214
States and political subdivisions		-		263,831		14,261		278,092
Corporate bonds		-		833		-		833
Collateralized mortgage obligations		-		63,671		2,268		65,939
Asset-backed securities		-		112,932		-		112,932
Collateralized loan obligations		-		54,421		-		54,421
Loans held-for-sale		-		4,067		-		4,067
Mortgage servicing rights		-		-		6,944		6,944
Interest rate swap agreements		-		727		-		727
Mortgage banking derivatives		-		238		-		238
Total	$	3,947	$	525,995	$	23,473	$	553,415

Liabilities:
Interest rate swap agreements	$	-	$	2,014	$	-	$	2,014
Total	$	-	$	2,014	$	-	$	2,014

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

The changes in Level 3 assets and liabilities measured at fair value on a recurring basis are as follows:


	Nine Months Ended September 30, 2018
	Securities available-for-sale
	Collateralized		States and		Mortgage
	Mortgage		Political		Servicing
	Obligation		Subdivisions		Rights
Beginning balance January 1, 2018	$	2,268	$	14,261	$	6,944
Transfers into Level 3		-		-		-
Transfers out of Level 3		-		-		-
Total gains or losses
Included in earnings (or changes in net assets)		32		-		636
Included in other comprehensive income		34		(805)		-
Purchases, issuances, sales, and settlements
Purchases		-		20,421		-
Issuances		-		-		997
Settlements		(770)		(24,366)		(446)
Ending balance September 30, 2018	$	1,564	$	9,511	$	8,131


	Nine Months Ended September 30, 2017
	Securities available-for-sale
	Collateralized		States and		Mortgage
	Mortgage		Political		Servicing
	Obligation		Subdivisions		Rights
Beginning balance January 1, 2017	$	3,119	$	22,226	$	6,489
Transfers into Level 3		-		-		-
Transfers out of Level 3		-		-		-
Total gains or losses
Included in earnings (or changes in net assets)		32		-		(354)
Included in other comprehensive income		7		(501)		-
Purchases, issuances, sales, and settlements
Purchases		-		10,994		-
Issuances		-		-		951
Settlements		(666)		(20,359)		(402)
Ending balance September 30, 2017	$	2,492	$	12,360	$	6,684

The following table and commentary presents quantitative and qualitative information about Level 3 fair value measurements as of September 30, 2018:

Weighted

Measured at fair value

Unobservable

Average

on a recurring basis:

Fair Value

Valuation Methodology

Inputs

Range of Input

of Inputs

Mortgage servicing rights

8,131

Discounted Cash Flow

Discount Rate

7.0 - 302.1%

10.2

Prepayment Speed

7.0 - 68.9%

8.1

Table of Contents

Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

The following table and commentary presents quantitative and qualitative information about Level 3 fair value measurements as of December 31, 2017:

Weighted

Measured at fair value

Unobservable

Average

on a recurring basis:

Fair Value

Valuation Methodology

Inputs

Range of Input

of Inputs

Mortgage servicing rights

6,944

Discounted Cash Flow

Discount Rate

10.0 - 34.3%

10.2

Prepayment Speed

7.0 - 68.4%

9.6

In addition to the above, Level 3 fair value measurement included $9.5 million for state and political subdivisions representing various local municipality securities and $1.6 million of collateralized mortgage obligations at September 30, 2018. Both of these were classified as securities available-for-sale, and were valued using a discount based on market spreads of similar assets, but the liquidity premium was an unobservable input. The state and political subdivisions securities balance in Level 3 fair value at September 30, 2017, was $12.4 million and collateralized mortgage obligation balance in Level 3 was $2.5 million. Both of these were classified as securities available-for-sale, and were valued using a discount based on market spreads of similar assets, but the liquidity premium was an unobservable input.

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis:

The Company may be required, from time to time, to measure certain other assets at fair value on a nonrecurring basis in accordance with GAAP. These assets consist of impaired loans and OREO. For assets measured at fair value on a nonrecurring basis at September 30, 2018, and December 31, 2017, respectively, the following tables provide the level of valuation assumptions used to determine each valuation and the carrying value of the related assets:


	September 30, 2018
	Level 1		Level 2		Level 3		Total
Impaired loans1	$	-	$	-	$	9,269	$	9,269
Other real estate owned, net2		-		-		6,964		6,964
Total	$	-	$	-	$	16,233	$	16,233

1 Represents carrying value and related write-downs of loans for which adjustments are substantially based on the appraised value of collateral for collateral-dependent loans; had a carrying amount of $9.6 million and a valuation allowance of $373,000 resulting in an increase of specific allocations within the allowance for loan and lease losses of $229,000 for the nine months ended September 30, 2018.

2 OREO is measured at the lower of carrying or fair value less costs to sell, and had a net carrying amount of $7.0 million, which is made up of the outstanding balance of $15.9 million, net of a valuation allowance of $8.0 million and participations of $937,000 at September 30, 2018.


	December 31, 2017
	Level 1		Level 2		Level 3		Total
Impaired loans1	$	-	$	-	$	5,113	$	5,113
Other real estate owned, net2		-		-		8,371		8,371
Total	$	-	$	-	$	13,484	$	13,484

1 Represents carrying value and related write-downs of loans for which adjustments are substantially based on the appraised value of collateral for collateral-dependent loans; had a carrying amount of $5.3 million and a valuation allowance of $144,000, resulting in an increase of specific allocations within the allowance for loan and lease losses of $856,000 for the year December 31, 2017.

2 OREO is measured at the lower of carrying or fair value less costs to sell, and had a net carrying amount of $8.4 million, which is made up of the outstanding balance of $17.5 million, net of a valuation allowance of $8.2 million and participations of $937,000, at December 31, 2017.

The Company has estimated the fair values of these assets based primarily on Level 3 inputs. OREO and impaired loans are generally valued using the fair value of collateral provided by third party appraisals. These valuations include assumptions related to cash flow projections, discount rates, and recent comparable sales. The numerical ranges of unobservable inputs for these valuation assumptions are not meaningful.

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Note 14 – Fair Values of Financial Instruments

The estimated fair values approximate carrying amount for all items except those described in the following table. Securities available-for-sale fair values are based upon market prices or dealer quotes, and if no such information is available, on the rate and term of the security. The carrying value of FHLBC stock approximates fair value as the stock is nonmarketable and can only be sold to the FHLBC or another member institution at par. FHLBC stock is carried at cost and considered a Level 2 fair value. For September 30, 2018, the fair values of loans and leases are estimated on an exit price basis incorporating discounts for credit, liquidity and marketability factors. This is not comparable with the fair value disclosures for December 31, 2017, which were estimated using an entrance price basis. For December 31, 2017, fair values of variable rate loans and leases with no significant change in credit risk were based on carrying values. The fair values of other loans and leases were estimated using discounted cash flow analyses which used interest rates being offered for loans and leases with similar terms to borrowers of similar credit quality. The fair value of time deposits is estimated using discounted future cash flows at current rates offered for deposits of similar remaining maturities. The fair values of borrowings were estimated based on interest rates available to the Company for debt with similar terms and remaining maturities. The fair value of off balance sheet volume is not considered material.

The carrying amount and estimated fair values of financial instruments were as follows:


	September 30, 2018
	Carrying		Fair
	Amount		Value		Level 1		Level 2		Level 3
Financial assets:
Cash and due from banks	$	34,366	$	34,366	$	34,366	$	-	$	-
Interest bearing deposits with financial institutions		15,956		15,956		15,956		-		-
Securities available-for-sale		542,338		542,338		3,854		527,409		11,075
FHLBC and FRBC Stock		10,511		10,511		-		10,511		-
Loans held-for-sale		2,911		2,911		-		2,911		-
Net loans		1,815,621		1,801,489		-		-		1,801,489
Interest rate swap agreements		1,135		1,135		-		1,135
Accrued interest receivable		10,460		10,460		-		10,460		-

Financial liabilities:
Noninterest bearing deposits	$	621,580	$	621,580	$	621,580	$	-	$	-
Interest bearing deposits		1,510,790		1,583,984		-		1,583,984		-
Securities sold under repurchase agreements		44,333		44,333		-		44,333		-
Other short-term borrowings		81,875		81,875		-		81,875		-
Junior subordinated debentures		57,674		59,104		33,336		25,769		-
Senior notes		44,133		45,693		-		45,693		-
Note payable and other borrowings		18,050		18,050		-		18,050		-
Borrowing interest payable		801		801		-		801		-
Deposit interest payable		924		924		-		924		-

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)


	December 31, 2017
	Carrying		Fair
	Amount		Value		Level 1		Level 2		Level 3
Financial assets:
Cash and due from banks	$	37,444	$	37,444	$	37,444	$	-	$	-
Interest bearing deposits with financial institutions		18,389		18,389		18,389		-		-
Securities available-for-sale		541,439		541,439		3,947		520,963		16,529
FHLBC and FRBC Stock		10,168		10,168		-		10,168		-
Loans held-for-sale		4,067		4,067		-		4,067		-
Net loans		1,600,161		1,586,722		-		-		1,586,722
Accrued interest receivable		8,595		8,595		-		8,595		-

Financial liabilities:
Noninterest bearing deposits	$	572,404	$	572,404	$	572,404	$	-	$	-
Interest bearing deposits		1,350,521		1,346,339		-		1,346,339		-
Securities sold under repurchase agreements		29,918		29,918		-		29,918		-
Other short-term borrowings		115,000		115,000		-		115,000		-
Junior subordinated debentures		57,639		59,471		33,267		26,204		-
Subordinated debenture		44,058		46,743		-		46,743		-
Interest rate swap agreements		1,287		1,287		-		1,287		-
Borrowing interest payable		140		140		-		140		-
Deposit interest payable		631		631		-		631		-

Note 15 – Derivatives, Hedging Activities and Financial Instruments with Off-Balance Sheet Risk

Risk Management Objective of Using Derivatives

The Company is exposed to certain risk arising from both its business operations and economic conditions. The Company principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Company manages economic risks, including interest rate, liquidity, and credit risk primarily by managing the amount, sources, and duration of its assets and liabilities and the use of derivative financial instruments. Specifically, the Company enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. The Company’s derivative financial instruments are used to manage differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments principally related to the Company’s loan portfolio.

Cash Flow Hedges of Interest Rate Risk

The Company’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable-rate amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount. During 2018, such derivatives were used to hedge the variable cash flows associated with existing variable-rate borrowings.

For derivatives designated and that qualify as cash flow hedges of interest rate risk, the gain or loss on the derivative is recorded in Accumulated Other Comprehensive Income and subsequently reclassified into interest expense in the same period(s) during which the hedged transaction affects earnings. Amounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest payments are received on the Company’s variable-rate borrowings. During the next twelve months, the Company estimates that an additional $18,000 will be reclassified as a reduction to interest expense.

Non-designated Hedges

Derivatives not designated as hedges are not speculative and result from a service the Company provides to certain customers. The Company executes interest rate swaps with commercial banking customers to facilitate their respective risk management strategies. Those interest rate swaps are simultaneously hedged by offsetting derivatives that the Company executes with a third party, such that the Company minimizes its net risk exposure resulting from such transactions. As the interest rate derivatives associated with this

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

program do not meet the strict hedge accounting requirements, changes in the fair value of both the customer derivatives and the offsetting derivatives are recognized directly in earnings.

The Company also grants mortgage loan interest rate lock commitments to borrowers, subject to normal loan underwriting standards. The interest rate risk associated with these loan interest rate lock commitments is managed with contracts for future deliveries of loans as well as selling forward mortgage-backed securities contracts. Loan interest rate lock commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Commitments to originate residential mortgage loans held-for-sale and forward commitments to sell residential mortgage loans or forward MBS contracts are considered derivative instruments and changes in the fair value are recorded to mortgage banking revenue. Fair values are estimated based on observable changes in mortgage interest rates including mortgage-backed securities prices from the date of the commitment.

Disclosure of Fair Values of Derivative Instruments on the Balance Sheet

The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the Balance Sheet as of September 30, 2018 and December 31, 2017.

Fair Value of Derivative Instruments


			Asset Derivatives				Liability Derivatives
			September 30, 2018		December 31, 2017		September 30, 2018		December 31, 2017
	No. of Trans.	Notional Amount $	Balance Sheet Location	Fair Value $	Balance Sheet Location	Fair Value $	Balance Sheet Location	Fair Value $	Balance Sheet Location	Fair Value $
Derivatives designated as hedging instruments
Interest rate swaps	1	25,774	Other Assets	1,135	Other Assets	-	Other Liabilities	-	Other Liabilities	1,287
Total derivatives designated as hedging instruments				1,135		-		-		1,287

Derivatives not designated as hedging instruments
Interest rate swaps with commercial loan customers	25	168,394	Other Assets	2,803	Other Assets	727	Other Liabilities	2,803	Other Liabilities	727
Interest rate lock commitments and forward contracts	96	25,250	Other Assets	151	Other Assets	238	Other Liabilities	-	Other Liabilities	-
Other contracts	3	15,806	Other Assets	-	Other Assets	-	Other Liabilities	3	Other Liabilities	13
Total derivatives not designated as hedging instruments				2,954		965		2,806		740

Disclosure of the Effect of Fair Value and Cash Flow Hedge Accounting

The fair value and cash flow hedge accounting related to derivatives covered under ASC Subtopic 815-20 impacted Accumulated Other Comprehensive Income (“AOCI”) and the Income Statement. The gain recognized in AOCI on derivatives totaled $599,000 as of September 30, 2018, and a loss in AOCI of $80,000 as of September 30, 2017. The amount of the gain (loss) reclassified from AOCI to interest income on the income statement totaled ($29,000) and ($101,000) for the three months ended September 30, 2018, and September 30, 2017, respectively. The amount of the gain (loss) reclassified from AOCI to interest income or interest expense on the income statement totaled ($145,000) and ($119,000) for the nine months ended September 30, 2018, and September 30, 2017, respectively.

Credit-risk-related Contingent Features

For derivative transactions involving counterparties who are lending customers of the Company, the derivative credit exposure is managed through the normal credit review and monitoring process, which may include collateralization, financial covenants and/or financial guarantees of affiliated parties. Agreements with such customers require that losses associated with derivative transactions receive payment priority from any funds recovered should a customer default and ultimate disposition of collateral or guarantees occur.

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Old Second Bancorp, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Dollar amounts in thousands, except per share data, unaudited)

Credit exposure to broker/dealer counterparties is managed through agreements with each derivative counterparty that require collateralization of fair value gains owed by such counterparties. Some small degree of credit exposure exists due to timing differences between when a gain may occur and the subsequent point in time that collateral is delivered to secure that gain. This is monitored by the Company and procedures are in place to minimize this exposure. Such agreements also require the Company to collateralize counterparties in circumstances wherein the fair value of the derivatives result in loss to the Company.

Other provisions of such agreements include the definition of certain events that may lead to the declaration of default and/or the early termination of the derivative transaction(s):

if the Company either defaults or is capable of being declared in default on any of its indebtedness (exclusive of deposit obligations), then the Company could also be declared in default on its derivative obligations.

if a merger occurs that materially changes the Company's creditworthiness in an adverse manner.

If certain specified adverse regulatory actions occur, such as the issuance of a Cease and Desist Order, or citations for actions considered Unsafe and Unsound or that may lead to the termination of deposit insurance coverage by the Federal Deposit Insurance Corporation.

As of September 30, 2018, there were no derivatives in a net liability position. As of September 30, 2018, the Company has not posted any collateral related to derivatives agreements.

The Bank also issues letters of credit, which are conditional commitments that guarantee the performance of a customer to a third party. The credit risk involved and collateral obtained in issuing letters of credit are essentially the same as that involved in extending loan commitments to our customers. In addition to customer related commitments, the Company is responsible for letters of credit commitments that relate to properties held in OREO. The following table represents the Company’s contractual commitments due to letters of credit as of September 30, 2018, and December 31, 2017.

The following table is a summary of letter of credit commitments (in thousands):


	September 30, 2018						December 31, 2017
	Fixed		Variable		Total		Fixed		Variable		Total
Letters of credit:
Borrower:
Financial standby	$	327	$	7,165	$	7,492	$	177	$	3,770	$	3,947
Commercial standby		-		388		388		-		354		354
Performance standby		532		7,074		7,606		241		7,594		7,835
		859		14,627		15,486		418		11,718		12,136
Non-borrower:
Performance standby		-		67		67		-		142		142
Total letters of credit	$	859	$	14,694	$	15,553	$	418	$	11,860	$	12,278

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Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

The following management’s discussion and analysis presents information concerning our financial condition as of September 30, 2018, as compared to December 31, 2017, and our results of operations for the three and nine months ended September 30, 2018 and September 30, 2017. This discussion and analysis is best read in conjunction with our consolidated financial statements as well as the financial and statistical data appearing elsewhere in this report and our Form 10-K for the year ended December 31, 2017. The results of operations for the quarter and nine months ended September 30, 2018, are not necessarily indicative of future results.

In this report, unless the context suggests otherwise, references to the “Company,” “we,” “us,” and “our” mean the combined business of Old Second Bancorp, Inc. and its subsidiary bank, Old Second National Bank (the “Bank”).

We have made, and will continue to make, various forward-looking statements with respect to financial and business matters. Comments regarding our business that are not historical facts are considered forward-looking statements that involve inherent risks and uncertainties. Actual results may differ materially from those contained in these forward-looking statements. For additional information regarding our cautionary disclosures, see the “Cautionary Note Regarding Forward-Looking Statements” on page 3 of this report.

Business Overview

The Company is a banking holding company headquartered in Aurora, Illinois. Through our wholly-owned subsidiary bank, Old Second National Bank, a national banking organization also headquartered in Aurora, Illinois, we offer a wide range of financial services through our 29 banking centers located in Cook, Kane, Kendall, DeKalb, DuPage, LaSalle and Will counties in Illinois. These banking centers offer access to a full range of traditional retail and commercial banking services including treasury management operations as well as fiduciary and wealth management services. We focus our business on establishing and maintaining relationships with our clients while maintaining a commitment to provide for the financial services needs of the communities in which we operate. We emphasize relationships with individual customers as well as small to medium-sized businesses throughout our market area. We also have extensive wealth management services, which includes a registered investment advisory platform in addition to trust administration and trust services related to personal and corporate trusts and employee benefit plan administration services.

Financial Overview

Our community-focused banking franchise experienced total asset and overall market growth in the third quarter of 2018, compared to the fourth quarter and third quarter of 2017, and we believe we are positioned for further growth as we continue to serve our customers’ needs in a competitive economic environment. While industry and regulatory developments in the past few years have made it challenging to attain the levels of profitability and growth reflected prior to the economic recession of 2007-2009, we are continuing to seek to provide value to our customers and the communities in which we operate, by executing on growth opportunities in our local markets and developing new banking relationships.

The following provides an overview of some of the factors impacting our financial performance for the three and nine month periods ending September 30, 2018:

This is the second quarter of results of operations that included our recent acquisition of Greater Chicago Financial Corp., and its wholly-owned subsidiary bank, ABC Bank, which closed on April 20, 2018.

Net income for the third quarter of 2018 was $9.6 million, or $0.32 per diluted share, compared to $8.1 million, or $0.27 per diluted share, for the third quarter of 2017. Net income for the nine months ended September 30, 2018, totaled $25.4 million, or $0.84 per diluted share, compared to $17.7 million, or $0.59 per diluted share for the nine months ended September 30, 2017.

Net interest and dividend income was $23.7 million for the third quarter of 2018, compared to $19.3 million for the quarter ended September 30, 2017. Net interest and dividend income was $66.6 million for the nine months ended September 30, 2018, compared to $55.5 million for the like period in 2017.

Noninterest income was $7.8 million for both the third quarter of 2018 and the third quarter of 2017. Noninterest income was $24.9 million for the nine months ended September 30, 2018, which reflected an increase of $2.7 million, or 12.0%, over the like period in 2017, due primarily to a $1.0 million BOLI death benefit recorded in the first quarter of 2018, as well as increases in interest rate driven mark to market adjustments on mortgage servicing rights.

Noninterest expense was $18.7 million for the third quarter of 2018, which reflects an increase of $1.8 million, or 10.6%, from the third quarter of 2017. For the nine months ended September 30, 2018, noninterest expense totaled $58.4 million, an

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increase of $5.4 million, or 10.2%, over the like period in 2017. Increases noted were primarily due to acquisition-related costs recorded in 2018 stemming from our acquisition of ABC Bank.

Asset quality remained consistent, with nonperforming loans as a percent of total loans declining to 0.6% as of September 30, 2018 from 1.0% as of September 30, 2017. We added $11.4 million of purchase credit impaired loans (“PCI loans”), net of purchase accounting adjustments, in our acquisition of ABC Bank in the second quarter of 2018. As of September 30, 2018, PCI loans, net of purchase accounting adjustments, totaled $10.9 million, and PCI loans to total loans were 0.6%. We had no PCI loans before our acquisition of ABC Bank.

Income tax expense increased in the 2018 periods reported compared to the like 2017 periods due primarily to a $2.9 million increase in pre-tax income for the third quarter of 2018 compared to the third quarter of 2017, and a $8.7 million increase in pre-tax income for the nine months ended September 30, 2018 compared to the like 2017 period. In addition, an increase in the State of Illinois income tax became effective on July 1, 2017, and resulted in the remeasurement of our deferred tax asset and a $1.6 million tax benefit in the third quarter of 2017. These increases in income tax expense and the provision for income taxes for the quarter and nine months ended September 30, 2018, compared to the like periods in 2017, were partially offset by the enactment of the “Tax Cuts and Jobs Act,” which became effective on January 1, 2018, and lowered the Federal corporate income tax rate to 21%.

Recent Developments

On April 20, 2018, we completed our previously announced acquisition of Greater Chicago Financial Corp., and its wholly-owned bank subsidiary, ABC Bank. In connection with the merger, Greater Chicago Financial Corp merged with and into the Company, with the Company as the surviving company in the merger. Immediately following the merger, ABC Bank, an Illinois state-chartered bank and wholly owned subsidiary of Greater Chicago Financial Corp., merged with and into the Bank, with the Bank as the surviving bank. With the acquisition of ABC Bank, we acquired four branches in the Chicago, Illinois, metropolitan area. We acquired $227.6 million of loans, net of purchase accounting adjustments, and $248.5 million of deposits, net of purchase accounting adjustments for time deposits, in the acquisition.

Critical Accounting Policies

The Company’s consolidated financial statements are prepared based on the application of accounting policies in accordance with generally accepted accounting principles (“GAAP”) and follow general practices within the banking industry. These policies require the reliance on estimates and assumptions, which may prove inaccurate or are subject to variations. These estimates, assumptions, and judgments are based on information available as of the date of the consolidated financial statements. Future changes in information may affect these estimates, assumptions, and judgments, which, in turn, may affect amounts reported in the consolidated financial statements. Changes in underlying factors, assumptions, or estimates could have a material impact on the Company’s future financial condition and results of operations. The most critical of these significant accounting policies are the policies related to the allowance for loan and lease losses, fair valuation methodologies and income taxes. In addition, as a result of our acquisition of Greater Chicago Financial Corporation and its wholly-owned subsidiary, ABC Bank, that closed on April 20, 2018, the Company has implemented accounting policies regarding loans purchased in a business combination, as discussed below and more fully described in Note 1 to our unaudited consolidated financial statements contained in this Quarterly Report on Form 10-Q.

Loans Acquired in Business Combinations

We record purchased loans at fair value at the date of acquisition based on a discounted cash flow methodology that considers various factors, including the type of loan and related collateral, classification status, whether the loan has a fixed or variable interest rate, its term and whether or not the loan was amortizing, and our assessment of risk inherent in the cash flow estimates. These cash flow evaluations are inherently subjective as they require material estimates, all of which may be susceptible to significant change. Purchased loans are segregated into two categories upon purchase: (1) loans purchased without evidence of deteriorated credit quality since origination, referred to as purchased non-credit impaired (“non-PCI”) loans, and (2) loans purchased with evidence of deteriorated credit quality since origination for which it is probable that all contractually required payments will not be collected, referred to as purchased credit impaired (“PCI”) loans.

We account for and evaluate PCI loans for impairment in accordance with the provisions of ASC 310-30. We estimate the cash flows expected to be collected on purchased loans based upon the expected remaining life of the loans, which includes the effects of estimated prepayments. Cash flow evaluations are inherently subjective as they require material estimates, all of which may be susceptible to significant change. We will perform re-estimations of cash flows on our PCI loan portfolio on a quarterly basis. Any decline in expected cash flows as a result of these re-estimations, due in any part to a change in credit, is deemed credit impairment, and recorded as provision for loan and lease losses during the period. Any decline in expected cash flows due only to changes in expected timing of cash flows is recognized prospectively as a decrease in yield on the loan and any improvement in expected cash flows, once any previously recorded impairment is recaptured, is recognized prospectively as an adjustment to the yield on the loan.

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Non-PCI loans outside the scope of ASC 310-30 are accounted for under ASC 310-20. For non-PCI loans, credit discounts representing the principal losses expected over the life of the loan are a component of the initial fair value and the discount is accreted to interest income over the life of the loan. Subsequent to the purchase date, the method used to evaluate the sufficiency of the credit discount is similar to organic loans, and if necessary, additional reserves are recognized in the allowance for loan and lease losses.

No Other Material Changes in Significant Accounting Policies

The Company’s significant accounting policies are more fully described in Note 1 to the audited consolidated financial statements contained in our Annual Report on Form 10-K for the year ended December 31, 2017, and the more significant assumptions and estimates made by management are more fully described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies” in our Annual Report on Form 10-K for the year ended December 31, 2017. Other than as described above, there have been no material changes to the Company’s significant accounting policies or the estimates made pursuant to those policies from those disclosed in our 2017 Annual Report on Form 10-K during the most recent quarter.

Non-GAAP Financial Measures

This report contains references to financial measures that are not defined in GAAP. Such non-GAAP financial measures include the presentation of net interest income and net interest income to interest earning assets on a tax equivalent (“TE”) basis, our adjusted efficiency ratio and our tangible common equity to tangible assets ratio. Management believes that the presentation of these non-GAAP financial measures (a) provides important supplemental information that contributes to a proper understanding of our operating performance, (b) enables a more complete understanding of factors and trends affecting our business, and (c) allows investors to evaluate our performance in a manner similar to management, the financial services industry, bank stock analysts, and bank regulators. Management uses non-GAAP measures as follows: in the preparation of our operating budgets, monthly financial performance reporting, and in our presentation to investors of our performance. However, we acknowledge that these non-GAAP financial measures have a number of limitations. Limitations associated with non-GAAP financial measures include the risk that persons might disagree as to the appropriateness of items comprising these measures and that different companies might calculate these measures differently. These disclosures should not be considered an alternative to our GAAP results. A reconciliation of non-GAAP financial measures to the most directly comparable GAAP financial measures is presented below or alongside the first instance where each non-GAAP financial measure is used.

Results of Operations

Three months ended September 30, 2018 and 2017

Our net income before taxes was $12.8 million in the third quarter of 2018 compared to $9.9 million in the third quarter of 2017. Net interest and dividend income increased $4.5 million, and noninterest income remained steady at $7.8 million in both the third quarter of 2018 and 2017. The increase in pre-tax income was also due to no provision for loan and lease loss expense being recorded in the third quarter of 2018, compared to $300,000 recorded in the third quarter of 2017. Partially offsetting the increase in pre-tax income was an increase of $1.8 million in noninterest expense due primarily to an increase in salaries and employee benefits and other expenses, partially offset by net gains on OREO sales in the third quarter of 2018.

The increase in net interest and dividend income was driven primarily by rising interest rates and loan growth due to the ABC Bank acquisition. Loans acquired, net of the purchase accounting adjustments, totaled $227.6 million in the second quarter of 2018. Loans and loans held for sale yielded 5.0% in the third quarter of 2018, compared to 4.6% in the third quarter of 2017.

Management has remained diligent in reviewing our loan portfolio to analyze and to determine if charge-offs are required. Due to an increasingly competitive loan origination environment, coupled with significant loan paydowns, there was no net loan growth in the third quarter of 2018, compared to the prior linked quarter. Management’s review of the loan portfolio concluded that no additional provision expense was necessary, based on analysis of the allowance and loan portfolio held. The allowance for loan and lease loss analysis methodology remained consistent, with no material changes incorporated in the third quarter of 2018 from the prior quarter. Management determined an additional provision for loan and lease losses of $300,000 was appropriate for the quarter ended September 30, 2017.

Earnings for the third quarter of 2018 were $0.32 per diluted share on $9.6 million of net income, as compared to $0.27 per diluted share on net income of $8.1 million for the third quarter of 2017. Earnings in the 2018 period, compared to the like 2017 period, were positively impacted by increased loan volumes due to the ABC Bank acquisition, as well as the favorable impact of a rising interest rate environment and the federal income tax rate reduction to 21% from 35% stemming from the “Tax Cuts and Jobs Act” passed in late 2017.

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Nine months ended September 30, 2018 and 2017

Our net income before taxes was $32.4 million for the nine months ended September 30, 2018, compared to $23.7 million for the nine months ended September 30, 2017. Net interest and dividend income increased $11.1 million, and noninterest income increased $2.7 million for the nine months ended September 30, 2018, compared to the like period in 2017. The increase in pre-tax income was partially offset by a $5.4 million increase in noninterest expenses for the nine months ended September 30, 2018, compared to the like period in 2017, due primarily to acquisition-related costs incurred year to date of $3.3 million, pre-tax, partially offset by net gains on OREO sales and a decrease in OREO related operating costs due to a decline in OREO for the nine months ended September 30, 2018.

The increase in net interest and dividend income was driven primarily by rising interest rates and the ABC Bank acquisition, while the increase in noninterest income was primarily due to a $1.0 million death benefit received on a BOLI claim in the first quarter of 2018, as well as increases in interest rate driven mark to market adjustment on mortgage servicing rights.

Earnings for the nine month period ending September 30, 2018, were $0.84 per diluted share on $25.4 million of net income, as compared to $0.59 per diluted share on net income of $17.7 million for the nine month period ending September 30, 2017. Earnings in the 2018 period, compared to the like 2017 period, were positively impacted by increased loan volumes due to the ABC Bank acquisition, recoveries on a few nonperforming credits and the BOLI death benefit in the first quarter of 2018, as well as the favorable impact of a rising interest rate environment and the federal income tax rate reduction to 21% from 35% stemming from the “Tax Cuts and Jobs Act” passed in late 2017. The performance of our loan portfolio, the impact of the restructuring of our securities portfolio into higher yielding instruments and organic loan growth in the year over year period also contributed to the increase in earnings for the 2018 period.

Net Interest Income

Net interest income, which is our primary source of earnings, is the difference between interest income earned on interest-earning assets, such as loans and investment securities, as well as accretion income on purchased loans, and interest incurred on interest-bearing liabilities, such as deposits and borrowings. Net interest income depends upon the relative mix of interest-earning assets and interest-bearing liabilities, the ratio of interest-earning assets to total assets and of interest-bearing liabilities to total funding sources, and movements in market interest rates. Our net interest income can be significantly influenced by a variety of factors, including overall loan demand, economic conditions, credit risk, the amount of nonearning assets including nonperforming loans and OREO, the amounts of and rates at which assets and liabilities reprice, variances in prepayment of loans and securities, early withdrawal of deposits, exercise of call options on borrowings or securities, a general rise or decline in interest rates, changes in the slope of the yield-curve, and balance sheet growth or contraction.

Three months ended September 30, 2018 and 2017

Net interest and dividend income increased by $4.5 million from $19.3 million for the quarter ended September 30, 2017, to $23.7 million for the quarter ended September 30, 2018. Our interest and dividend income increased $915,000, or 3.4%, for the quarter ended September 30, 2018 compared to the second quarter of 2018, and reflected an increase of $5.8 million, or 25.6%, compared to the third quarter of 2017. Tax equivalent interest and dividend income increased by $5.4 million from $23.3 million for the quarter ended September 30, 2017, to $28.7 million for the quarter ended September 30, 2018. Average earning assets for the quarter ended September 30, 2018 were $2.41 billion, reflecting an increase of $19.7 million compared to the second quarter of 2018, and an increase of $289.8 million compared to the third quarter of 2017. Total average loans, including loans held-for-sale, totaled $1.84 billion in the third quarter of 2018, which reflected an increase of $33.5 million compared to the second quarter of 2018, and an increase of $289.1 million compared to the third quarter of 2017. The growth in average balances and resultant interest income was primarily due to $227.6 million of loans acquired, net of purchase accounting adjustments, in our acquisition of ABC Bank on April 20, 2018. In addition, the rising interest rate environment in the 2018 period and the repositioning on our securities portfolio over the past year has driven higher yields and growth in interest and dividend income. Total securities yields have increased by 14 basis points for the quarter ended September 30, 2018, compared to the quarter ended September 30, 2017, due to the repositioning of our portfolio into higher yielding tax exempt securities. Our average tax exempt securities portfolio increased by $53.7 million in the third quarter of 2018 compared to the third quarter of 2017.

Quarterly average interest bearing liabilities increased $12.3 million, or 0.7%, in the third quarter of 2018, compared to the second quarter of 2018, and increased $202.8 million, or 13.0%, compared to the third quarter of 2017. Growth from the prior periods was primarily due to deposits of $248.5 million, net of purchase accounting adjustments, recorded in our acquisition of ABC Bank in the second quarter of 2018. In addition, an increase of $14.1 million was reflected in the average balances of securities sold under repurchase agreements. The average of other short-term borrowed funds, which primarily consist of FHLBC advances, reflected a decrease of $16.9 million in the third quarter of 2018, compared to the third quarter of 2017. The short-term FHLBC advances were impacted by the higher interest rate environment in the third quarter of 2018, reflecting a cost of funds of 2.24% compared to 1.90% for the second quarter of 2018, and 1.19% for the third quarter of 2017. The decrease in average short-term borrowings was offset by the increase in notes payable and other borrowings, which included long-term FHLBC advances acquired with the ABC Bank purchase. The average of these long-term advances totaled $20.8 million for the third quarter of 2018, and reflected a cost of funds of 3.30%.

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The rate on our junior subordinated debentures declined in the third quarter of 2018, compared to the third quarter of 2017, due to the rate conversion on the debt from fixed to floating rate at three month LIBOR plus 150 basis points on June 15, 2017. Upon conversion to a floating rate, we initiated a cash flow hedge that resulted in a reduction in the total interest rate paid on the debt from 6.77% prior to June 15, 2017, to 4.34% at September 30, 2018.

Our net interest margin (on a tax-equivalent basis), expressed as a percentage of average earning assets, was 4.00% in the third quarter of 2018, reflecting a one basis point increase from the second quarter of 2018, and an increase of 23 basis points from the third quarter of 2017. The average tax-equivalent yield on earning assets increased to 4.73% for the third quarter of 2018, compared to 4.67% for the second quarter of 2018 and 4.32% for the third quarter of 2017. Increases in net interest margin and yield on average earning assets for the third quarter of 2018 compared to the third quarter of 2017 was attributable to growth in loan volumes and rates, as well as the restructuring of our securities portfolio into higher yielding tax exempt holdings, as discussed above. The cost of funds on interest bearing liabilities was 1.00% for the third quarter of 2018, 0.92% for the second quarter of 2018, and 0.80% for the third quarter of 2017. The increase in our cost of funds in each period was driven by the rising interest rate environment, specifically impacting the rates on newly issued time deposits and FHLBC advances.

Nine months ended September 30, 2018 and 2017

Net interest and dividend income increased by $11.1 million from $55.5 million for the nine months ended September 30, 2017, to $66.6 million for the nine months ended September 30, 2018. Our interest and dividend income increased $13.7 million, or 21.2%, for the nine months ended September 30, 2018, compared to the nine months ended September 30, 2017. Tax equivalent interest and dividend income increased by $13.1 million from $67.2 million for the nine months ended September 30, 2017, to $80.3 million for the nine months ended September 30, 2018.

Our net interest margin (on a tax equivalent basis) for the nine months ended September 30, 2018, was 3.92% compared to 3.68% for the like 2017 period, reflecting a 24 basis point increase. Average earning assets for the nine months ended September 30, 2018, were $2.33 billion, reflecting an increase of $224.1 million compared to the nine months ended September 30, 2017. The yield on average earning assets for the nine months ended September 30, 2018, was 4.61%, compared to 4.22% for the nine months ended September 30, 2017. Average interest bearing liabilities for the nine months ended September 30, 2018, increased $138.2 million, or 8.9%, compared to the nine months ended September 30, 2017. The cost of funds for the nine months ended September 30, 2018, was 94 basis points, compared to the cost of funds of 80 basis points for the like 2017 period. Growth in volumes and rates has resulted in an increase for all line items presented, excluding the junior subordinated debentures and senior notes.

Management continued to observe competitive pressure to maintain reduced interest rates on loans retained at renewal. While the Bank prices loans to achieve certain return on equity targets, significant competition for both commercial and industrial as well as commercial real estate loans has put pressure on loan yields, and our stringent underwriting standards limit our ability to make higher-yielding loans.

The following tables set forth certain information relating to the Company’s average consolidated balance sheets and reflect the yield on average earning assets and cost of average interest bearing liabilities for the periods indicated. These yields reflect the related interest, on an annualized basis, divided by the average balance of assets or liabilities over the applicable period. Average balances are derived from daily balances. For purposes of discussion, net interest income and net interest income to total earning assets in the following tables have been adjusted to a non-GAAP tax equivalent (“TE”) basis using a marginal rate of 21% in 2018 and 35% in 2017 to more appropriately compare returns on tax-exempt loans and securities to other earning assets.

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ANALYSIS OF AVERAGE BALANCES,

TAX EQUIVALENT INTEREST AND RATES

(In thousands - unaudited)


	Quarters Ended
	September 30, 2018						June 30, 2018						September 30, 2017
	Average					Rate	Average					Rate	Average					Rate
	Balance			Interest		%	Balance			Interest		%	Balance			Interest		%
Assets
Interest bearing deposits with financial institutions	$	17,975		$	84	1.85	$	19,161		$	97	2.03	$	11,685		$	37	1.24
Securities:
Taxable		268,015			2,491	3.69		268,591			2,392	3.57		327,892			2,424	2.96
Non-taxable (TE)		274,282			2,612	3.78		286,611			2,676	3.74		220,540			2,504	4.54
Total securities		542,297			5,103	3.73		555,202			5,068	3.66		548,432			4,928	3.59
Dividends from FHLBC and FRBC		8,905			121	5.39		8,619			111	5.17		8,339			94	4.51
Loans and loans held-for-sale 1, 2		1,842,561			23,421	5.04		1,809,077			22,552	5.00		1,553,473			18,265	4.60
Total interest earning assets		2,411,738			28,729	4.73		2,392,059			27,828	4.67		2,121,929			23,324	4.32
Cash and due from banks		34,608			-	-		36,720			-	-		31,028			-	-
Allowance for loan and lease losses		(19,696)			-	-		(18,494)			-	-		(16,478)			-	-
Other noninterest bearing assets		191,296			-	-		176,608			-	-		185,906			-	-
Total assets	$	2,617,946					$	2,586,893					$	2,322,385

Liabilities and Stockholders' Equity
NOW accounts	$	444,790		$	301	0.27	$	443,586		$	238	0.22	$	422,913		$	108	0.10
Money market accounts		319,492			250	0.31		317,775			193	0.24		273,440			85	0.12
Savings accounts		300,519			91	0.12		298,240			70	0.09		262,573			46	0.07
Time deposits		467,933			1,568	1.33		460,909			1,444	1.26		389,037			1,077	1.10
Interest bearing deposits		1,532,734			2,210	0.57		1,520,510			1,945	0.51		1,347,963			1,316	0.39
Securities sold under repurchase agreements		46,850			140	1.19		44,655			104	0.93		32,800			4	0.05
Other short-term borrowings		55,119			311	2.24		58,199			276	1.90		72,065			220	1.19
Junior subordinated debentures		57,669			930	6.40		57,657			927	6.45		57,621			930	6.46
Senior notes		44,121			672	6.04		44,096			672	6.11		44,021			672	6.11
Notes payable and other borrowings		20,768			173	3.30		19,795			95	1.92		-			-	-
Total interest bearing liabilities		1,757,261			4,436	1.00		1,744,912			4,019	0.92		1,554,470			3,142	0.80
Noninterest bearing deposits		625,982			-	-		618,765			-	-		551,768			-	-
Other liabilities		20,142			-	-		15,679			-	-		19,395			-	-
Stockholders' equity		214,561			-	-		207,537			-	-		196,752			-	-
Total liabilities and stockholders' equity	$	2,617,946					$	2,586,893					$	2,322,385
Net interest income (TE) 2				$	24,293					$	23,809					$	20,182
Net interest margin (TE) 2						4.00						3.99						3.77
Interest bearing liabilities to earning assets		72.86	%					72.95	%					73.26	%

1 Interest income from loans is shown on a tax equivalent basis, which is a non-GAAP financial measure, as discussed in the table on page 45, and includes fees of $197,000, $233,000 and $722,000 for the third quarter of 2018, the second quarter of 2018, and the third quarter of 2017, respectively. Nonaccrual loans are included in the above-stated average balances.

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Analysis of Average Balances,
Tax Equivalent Interest and Rates
Nine Months Ended September 30, 2018, and 2017
(In thousands - unaudited)

	2018						2017
	Average					Rate	Average					Rate
	Balance			Interest		%	Balance			Interest		%
Assets
Interest bearing deposits with financial institutions	$	17,000		$	230	1.81	$	11,913		$	91	1.01
Securities:
Taxable		268,640			7,053	3.51		370,161			7,994	2.88
Non-taxable (TE)		280,221			7,897	3.77		196,120			6,443	4.38
Total securities		548,861			14,950	3.64		566,281			14,437	3.40
Dividends from FHLBC and FRBC		8,815			338	5.13		7,886			271	4.58
Loans and loans held-for-sale 1, 2		1,752,406			64,740	4.94		1,516,872			52,365	4.55
Total interest earning assets		2,327,082			80,258	4.61		2,102,952			67,164	4.22
Cash and due from banks		33,719			-	-		34,670			-	-
Allowance for loan and lease losses		(18,823)			-	-		(16,184)			-	-
Other noninterest bearing assets		178,228			-	-		189,533			-	-
Total assets	$	2,520,206					$	2,310,971

Liabilities and Stockholders' Equity
NOW accounts	$	439,283		$	715	0.22	$	427,242		$	316	0.10
Money market accounts		304,362			552	0.24		279,143			254	0.12
Savings accounts		288,499			220	0.10		262,352			125	0.06
Time deposits		437,401			4,187	1.28		392,049			3,081	1.05
Interest bearing deposits		1,469,545			5,674	0.52		1,360,786			3,776	0.37
Securities sold under repurchase agreements		43,951			323	0.98		32,764			10	0.04
Other short-term borrowings		66,802			916	1.83		62,308			472	1.00
Junior subordinated debentures		57,657			2,784	6.46		57,609			3,073	7.11
Senior notes		44,096			2,016	6.11		43,998			2,017	6.11
Notes payable and other borrowings		13,597			268	2.64		-			-	-
Total interest bearing liabilities		1,695,648			11,981	0.94		1,557,465			9,348	0.80
Noninterest bearing deposits		600,052			-	-		544,925			-	-
Other liabilities		16,619			-	-		20,814			-	-
Stockholders' equity		207,887			-	-		187,767			-	-
Total liabilities and stockholders' equity	$	2,520,206					$	2,310,971
Net interest income (TE) 2				$	68,277					$	57,816
Net interest margin (TE) 2						3.92						3.68
Interest bearing liabilities to earning assets		72.87	%					74.06	%

1 Interest income from loans is shown on a tax equivalent basis, which is a non-GAAP financial measure, as discussed in the table on page 45, and includes fees of $611,000 and $1.8 million for the nine months ended September 30, 2018 and 2017, respectively. Nonaccrual loans are included in the above-stated average balances.

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Reconciliation of Tax-Equivalent Non-GAAP Financial Measures

Net interest income and net interest income to earning assets have been adjusted to a non-GAAP TE basis using a marginal rate of 21% for 2018 and 35% for 2017 to more appropriately compare returns on tax-exempt loans and securities to other earning assets. The table below provides a reconciliation of each non-GAAP TE measure to the GAAP equivalent for the periods indicated:


	Three Months Ended									Nine Months Ended
	September 30,			June 30,			September 30,			September 30,
	2018			2018			2017			2018			2017
Net Interest Margin
Interest income (GAAP)	$	28,176		$	27,261		$	22,425		$	78,579		$	64,841
Taxable-equivalent adjustment:
Loans		5			5			23			21			68
Securities		548			562			876			1,658			2,255
Interest income (TE)		28,729			27,828			23,324			80,258			67,164
Interest expense (GAAP)		4,436			4,019			3,142			11,981			9,348
Net interest income (TE)	$	24,293		$	23,809		$	20,182		$	68,277		$	57,816
Net interest income (GAAP)	$	23,740		$	23,242		$	19,283		$	66,598		$	55,493
Average interest earning assets	$	2,411,738		$	2,392,059		$	2,121,929		$	2,327,082		$	2,102,952
Net interest margin (GAAP)		3.91	%		3.90	%		3.61	%		3.83	%		3.53	%
Net interest margin (TE)		4.00	%		3.99	%		3.77	%		3.92	%		3.68	%

Noninterest Income and Expense

The following table details the major components of noninterest income for the periods presented:


							3rd Quarter 2018
Noninterest Income	Three Months Ended						Percent Change From
(dollars in thousands)	September 30,		June 30,		September 30,		June 30,	September 30,
	2018		2018		2017		2018	2017
Trust income	$	1,644	$	1,645	$	1,468	(0.1)	12.0
Service charges on deposits		1,923		1,769		1,722	8.7	11.7
Residential mortgage banking revenue
Secondary mortgage fees		199		195		195	2.1	2.1
Mortgage servicing rights mark to market (loss) gain		(11)		(105)		(194)	89.5	94.3
Mortgage servicing income		471		627		451	(24.9)	4.4
Net gain on sales of mortgage loans		965		1,240		1,095	(22.2)	(11.9)
Total residential mortgage banking revenue		1,624		1,957		1,547	(17.0)	5.0
Securities gain, net		13		312		102	(95.8)	(87.3)
Increase in cash surrender value of BOLI		347		351		362	(1.1)	(4.1)
Debit card interchange income		1,135		1,132		1,075	0.3	5.6
Other income		1,128		1,366		1,567	(17.4)	(28.0)
Total noninterest income	$	7,814	$	8,532	$	7,843	(8.4)	(0.4)

Noninterest income for the third quarter of 2018 decreased $718,000, or 8.4%, compared to the second quarter of 2018, and decreased $29,000 from total noninterest income recorded in the third quarter of 2017.

The decrease in noninterest income in the third quarter of 2018, compared to the second quarter of 2018, was driven primarily by a reduction in total residential mortgage banking revenues of $333,000, stemming primarily from a decline in net gain on sales of mortgage loans and declines in originations of mortgage loans and subsequent sales of those loans due to rising interest rates. Securities gain, net, experienced the most significant decline, as a percentage of total change on a linked quarter basis, as minimal security activity occurred in the third quarter of 2018. In addition, commercial swap fee income, within other income above, declined by $235,000 from the second quarter of 2018 to the third quarter of 2018 due to a reduction in commercial loan originations. Partially offsetting these decreases to noninterest income was service charges on deposit accounts, which reflected an increase in the third quarter of 2018 over the prior linked quarter due to expansion of commercial deposit fees.

Noninterest income remained relatively consistent for the third quarter of 2018, decreasing 0.4% compared to the third quarter of 2017. Trust income increased $176,000 in the third quarter of 2018 compared to the third quarter of 2017, due to growth in assets under

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management. Service charges on deposit accounts reflected $201,000 of growth in the third quarter of 2018, compared to the third quarter of 2017 due to an increase in commercial account service charges, and mortgage servicing rights mark to market losses in the third quarter of 2018 were $183,000 less than the third quarter of 2017. These increases were more than offset by an $89,000 reduction in the third quarter 2018 securities gain, net, as well as a $546,000 reduction in commercial swap fee income, included within other income.

The following table details the major components of noninterest expense for the periods presented:


										3rd Quarter 2018
Noninterest Expense	Three Months Ended									Percent Change From
(dollars in thousands)	September 30,			June 30,			September 30,			June 30,	September 30,
	2018			2018			2017			2018	2017
Salaries	$	8,509		$	9,703		$	7,704		(12.3)	10.4
Officers incentive		820			740			1,114		10.8	(26.4)
Benefits and other		1,836			1,912			1,231		(4.0)	49.1
Total salaries and employee benefits		11,165			12,355			10,049		(9.6)	11.1
Occupancy, furniture and equipment expense		1,782			1,652			1,482		7.9	20.2
Computer and data processing		1,247			2,741			1,081		(54.5)	15.4
FDIC insurance		162			165			199		(1.8)	(18.6)
General bank insurance		230			299			246		(23.1)	(6.5)
Amortization of core deposit intangible asset		136			97			24		40.2	466.7
Advertising expense		492			492			255		-	92.9
Debit card interchange expense		320			301			285		6.3	12.3
Legal fees		243			286			162		(15.0)	50.0
Other real estate owned expense, net		(370)			429			680		(186.2)	(154.4)
Other expense		3,304			3,469			2,455		(4.8)	34.6
Total noninterest expense	$	18,711		$	22,286		$	16,918		(16.0)	10.6
Efficiency ratio (GAAP)		60.06	%		69.16	%		60.00	%
Adjusted efficiency ratio (non-GAAP)1		59.11	%		57.88	%		57.66	%

1 The adjusted efficiency ratio shown in the table above is a non-GAAP financial measure calculated as noninterest expense, excluding OREO expenses, amortization of core deposits and acquisition costs, divided by the sum of net interest income on a fully tax equivalent basis, total noninterest income less net gains and losses on securities and includes a tax equivalent adjustment on the increase in cash surrender value of BOLI and the BOLI death benefit recorded.

See the section entitled “Reconciliation of Adjusted Efficiency Ratio Non-GAAP Financial Measures” on page 48 for a reconciliation of this non-GAAP measure to the most comparable GAAP equivalent.

Noninterest expense for the third quarter of 2018 decreased $3.6 million, or 16.0%, compared to the second quarter of 2018, and increased $1.8 million, or 10.6%, compared to the third quarter of 2017.

The decrease in noninterest expense in the third quarter of 2018, compared to the second quarter of 2018, was primarily attributable to ABC Bank acquisition-related costs incurred in the second quarter of 2018, which included $1.2 million of salaries and employee benefit expense, $1.6 million of computer and data processing expense, and $114,000 of legal expense, as well as various costs within other expense for the second quarter of 2018 related to acquisition, such as appraisals, audit fees, and consulting expenses. The third quarter of 2018 reflects an increase in select noninterest expense items when compared to the prior linked quarter, such as occupancy, furniture and equipment expenses, and amortization of core deposit intangibles due to the impact of the ABC Bank acquisition. The decrease in noninterest expense in the third quarter of 2018 compared to the second quarter of 2018 was also driven by reduced OREO related costs, as a favorable variance of $588,000 of net gains on sale of OREO was recorded in the linked quarter, and our OREO portfolio balance continued to decline.

The increase in noninterest expense in the third quarter of 2018, compared to the third quarter of 2017, was primarily attributable to the impact of additional employees, occupancy costs, and core deposit intangible amortization stemming from the ABC Bank acquisition in the second quarter of 2018. The increase in noninterest expense in the third quarter of 2018 was partially offset by reduced OREO related costs in 2018, compared to the third quarter of 2017, as a favorable variance of $336,000 of net gains on sale of OREO was recorded in the third quarter of 2018, and our OREO portfolio balance continued to decline.

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Reconciliation of Adjusted Efficiency Ratio Non-GAAP Financial Measures


		Three Months Ended
	September 30,			June 30,			September 30,
	2018			2018			2017
Efficiency Ratio
Noninterest expense	$	18,711		$	22,286		$	16,918
Less amortization of core deposit		136			97			24
Less other real estate expense, net		(370)			429			680
Less acquisition related costs		(82)			3,168			-
Adjusted noninterest expense	$	19,027		$	18,592		$	16,214

Net interest income (GAAP)	$	23,740		$	23,242		$	19,283
Taxable-equivalent adjustment:
Loans		5			5			23
Securities		548			562			876
Net interest income (TE)		24,293			23,809			20,182
Noninterest income		7,814			8,532			7,843
Taxable-equivalent adjustment:
Increase in cash surrender value of BOLI (TE)		92			93			195
Noninterest income (TE)		7,906			8,625			8,038
Less securities gain (loss), net		13			312			102
Adjusted noninterest income, plus net interest income (TE)	$	32,186		$	32,122		$	28,118
Efficiency ratio (GAAP)		60.06	%		69.16	%		60.00	%
Adjusted efficiency ratio (non-GAAP)		59.11	%		57.88	%		57.66	%

Income Taxes

We recorded a tax expense of $3.2 million on $12.8 million of pre-tax income for the third quarter of 2018 compared to an income tax expense of $1.8 million in the second quarter of 2018 and $1.8 million of income tax expense in the third quarter of 2017. The effective tax rate for the third quarter of 2018 was 24.9%, an increase from 22.1% for the second quarter of 2018,and an increase from 18.5% in the third quarter of 2017. Lower tax rates were effective in 2017 due to the State of Illinois enactment of a tax rate increase on July 1 2017, which required a remeasurement of our deferred tax asset and a resultant income tax credit of $1.6 million that was recorded in the third quarter of 2017.

We recorded a tax expense of $7.0 million on $32.4 million of pre-tax income for the nine months ended September 30, 2018, compared to $6.0 million on $23.7 million of pre-tax income for the like 2017 period. The 2018 periods all reflect lower federal tax rates due to the “Tax Cuts and Jobs Act” which became effective January 1, 2018, and resulted in the federal corporate tax rate being reduced to 21% from 35%. The effective tax rate for the nine months ended September 30, 2018 was 21.6%, compared to 25.4% for the nine months ended September 30, 2017, due to the federal tax rate reduction, as well as the receipt of a $1.0 million death benefit realized on BOLI in the first quarter of 2018, which is not taxable. Income tax expense reflected all relevant statutory tax rates and GAAP accounting.

There were no significant changes in our ability to utilize the deferred tax assets during the quarter ended September 30, 2018. We had no valuation reserve on the deferred tax assets as of September 30, 2018.

Financial Condition

Total assets increased $229.0 million from $2.38 billion as of December 31, 2017, to $2.61 billion at September 30, 2018, due primarily to our acquisition of ABC Bank in the second quarter of 2018. Total loans as of September 30, 2018, increased $217.3 million, or 13.4%, compared to December 31, 2017. The securities portfolio totaled $542.3 million at September 30, 2018, an increase of $8.9 million from $541.4 million at December 31, 2017. Total deposits were $2.13 billion at September 30, 2018, an increase of $209.4 million from $1.92 billion at December 31, 2017, due primarily to the ABC Bank acquisition which contributed deposit growth of $248.5 million, net of purchase accounting adjustments.

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							September 30, 2018
Securities	As of						Percent Change From
(in thousands)	September 30,		December 31,		September 30,		December 31,	September 30,
	2018		2017		2017		2017	2017
Securities available-for-sale, at fair value
U.S. Treasuries	$	3,854	$	3,947	$	3,990	(2.4)	(3.4)
U.S. government agencies		11,703		13,061		13,451	(10.4)	(13.0)
U.S. government agencies mortgage-backed		14,766		12,214		11,030	20.9	33.9
States and political subdivisions		272,264		278,092		229,032	(2.1)	18.9
Corporate bonds		-		833		10,577	(100.0)	(100.0)
Collateralized mortgage obligations		64,960		65,939		80,386	(1.5)	(19.2)
Asset-backed securities		109,173		112,932		131,759	(3.3)	(17.1)
Collateralized loan obligations		65,618		54,421		53,259	20.6	23.2
Total securities	$	542,338	$	541,439	$	533,484	0.2	1.7

Available-for-sale security purchases during the nine months ended September 30, 2018, consisted primarily of collateralized loan obligations, whereas purchases during the year over year period were primarily tax exempt state and political subdivisions securities. We immediately liquidated the securities portfolio acquired with our acquisition of ABC Bank in the second quarter of 2018 as the holdings were not consistent with our investment strategies. This liquidation resulted in a cash inflow of approximately $72.1 million. During the third quarter of 2018 security sales resulted in net realized gains of $13,000, as compared to net realized gains of $639,000 for the fourth quarter of 2017 and net realized gains of $102,000 for the third quarter of 2017.

Loans

Total loans were $1.83 billion as of September 30, 2018, an increase of $217.3 million from total loans as of December 31, 2017. The increase in total loans was due primarily to our acquisition of ABC Bank in April 2018, which resulted in $227.6 million of loans recorded, net of purchase accounting adjustments. Significant loan payoffs continued to occur throughout 2018, and we continued to diversify our loan portfolio driving organic growth in commercial loans from December 31, 2017 to September 30, 2018.

Total loans increased $240.8 million from September 30, 2017 to September 30, 2018, due primarily to our acquisition of ABC Bank, as discussed above, as well as organic loan growth in commercial, real estate-construction, leases, and real estate-residential loans, the $21.8 million of high grade multifamily real estate loans we purchased in June 2018, and the $20.0 million home equity portfolio we purchased from TCF Bank in the first quarter of 2018.


							September 30, 2018
Loans	As of						Percent Change From
(in thousands)	September 30,		December 31,		September 30,		December 31,	September 30,
	2018		2017		2017		2017	2017
Commercial	$	306,407	$	272,851	$	257,356	12.3	19.1
Leases		70,661		68,325		69,305	3.4	2.0
Real estate - commercial		804,184		750,991		739,136	7.1	8.8
Real estate - construction		112,873		85,162		94,868	32.5	19.0
Real estate - residential		393,598		313,397		303,080	25.6	29.9
HELOC		122,022		112,833		116,503	8.1	4.7
Other 1		12,969		13,383		13,320	(3.1)	(2.6)
Total loans, excluding deferred loan costs and PCI loans		1,822,714		1,616,942		1,593,568	12.7	14.4
Net deferred loan costs		1,348		680		623	98.2	116.4
Total loans, excluding PCI loans		1,824,062		1,617,622		1,594,191	12.8	14.4
PCI loans, net of purchase accounting adjustments		10,887		-		-	N/M	N/M
Total loans	$	1,834,949	$	1,617,622	$	1,594,191	13.4	15.1

N/M - Not meaningful

1 The “Other” class includes consumer and overdrafts.

The quality of our loan portfolio is impacted not only by our credit decisions but also by the economic health of the communities in which we operate. Since we are located in a corridor with significant open space and undeveloped real estate, real estate lending (including commercial, construction, residential, and HELOCs) have been and continue to be a sizeable portion of our portfolio. These categories comprised 78.1% of the portfolio as of September 30, 2018, compared to 78.0% of the portfolio as of December 31, 2017. We continue to oversee and manage our loan portfolio in accordance with interagency guidance on risk management.

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Asset Quality

We recorded no provision for loan and lease losses for the quarter ended September 30, 2018, compared to a provision of $300,000 for the quarter ended September 30, 2017. We determined no additional reserves were necessary as there was no net loan growth for the quarter and runoffs on the acquired loan portfolios are trending with expectations. On a quarterly basis, management estimates the amount of provision required and records the appropriate provision expense or release to maintain an adequate reserve for all potential and estimated loan and lease losses.

Nonperforming loans consist of nonaccrual loans, performing restructured accruing loans and loans 90 days or greater past due. PCI loans with an accretable yield are considered current, and are not included within nonperforming loans. Remediation work continues in all segments. Nonperforming loans decreased by $3.8 million at September 30, 2018, from $15.6 million at December 31, 2017. Credit metrics continue to be relatively stable regarding nonperforming loan levels, and management is carefully monitoring loans considered to be in a classified status. Nonperforming loans as a percent of total loans decreased to 0.6% as of September 30, 2018, from 1.0% as of December 31, 2017, and September 30, 2017. The distribution of the Company’s nonperforming loans is shown in the following table.


							September 30, 2018
Nonperforming Loans	As of						Percent Change From
(in thousands)	September 30,		December 31,		September 30,		December 31,	September 30,
	2018		2017		2017		2017	2017
Commercial	$	6	$	-	$	207	N/M	(97.1)
Leases		-		178		345	(100.0)	(100.0)
Real estate-commercial, nonfarm		5,699		3,289		3,631	73.3	57.0
Real estate-commercial, farm		-		-		383	N/M	(100.0)
Real estate-construction		109		201		205	(45.8)	(46.8)
Real estate-residential:
Investor		365		372		492	(1.9)	(25.8)
Multifamily		73		4,723		4,757	(98.5)	(98.5)
Owner occupied		4,108		4,964		4,266	(17.2)	(3.7)
HELOC		1,379		1,890		1,977	(27.0)	(30.2)
Other 1		40		7		8	471.4	400.0
Total nonperforming loans	$	11,779	$	15,624	$	16,271	(24.6)	(27.6)
N/M - Not meaningful

1 The “Other” class includes consumer and overdrafts.

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Loan Charge-offs, net of recoveries	Three Months Ended
(in thousands)	September 30,		% of	June 30,		% of	September 30,		% of
	2018		Total1	2018		Total1	2017		Total1
Commercial	$	(25)	357.1	$	(77)	(24.3)	$	7	(2.1)
Leases		-	-		8	2.5		98	(29.8)
Real estate-commercial, nonfarm
Owner general purpose		(6)	85.7		27	8.5		-	-
Owner special purpose		192	(2,742.9)		-	-		-	-
Non-owner general purpose		(22)	314.3		(20)	(6.3)		(43)	13.1
Non-owner special purpose		-	-		476	150.2		-	-
Retail properties		-	-		-	-		22	(6.7)
Total real estate-commercial, nonfarm		164	(2,342.9)		483	152.4		(21)	6.4
Real estate-construction
Homebuilder		-	-		-	-		-	-
Land		(23)	328.6		(2)	(0.6)		-	-
Commercial speculative		-	-		-	-		-	-
All other		(9)	128.6		2	0.6		8	(2.4)
Total real estate-construction		(32)	457.2		-	-		8	(2.4)
Real estate-residential
Investor		(18)	257.1		(63)	(19.9)		(28)	8.5
Multifamily		(11)	157.1		(11)	(3.5)		(17)	5.2
Owner occupied		(54)	771.4		(26)	(8.2)		(40)	12.2
Total real estate-residential		(83)	1,185.6		(100)	(31.6)		(85)	25.9
HELOC		(90)	1,285.7		(26)	(8.2)		(367)	111.6
Other 2		59	(842.7)		29	9.2		31	(9.6)
Net charge-offs / (recoveries)	$	(7)	100.0	$	317	100.0	$	(329)	100.0

1 Represents the percentage of net charge-offs attributable to each category of loans.

2 The “Other” class includes consumer and overdrafts.

Net recoveries of $7,000 were recorded for the third quarter of 2018, compared to net charge-offs of $317,000 for the second quarter of 2018 and net recoveries of $329,000 for the third quarter of 2017, reflecting continuing management attention to credit quality and remediation efforts. We have continued our conservative loan valuations and aggressive recovery efforts on prior charge-offs.

The following table shows classified assets by segment for the following periods.


							September 30, 2018
Classified Assets	As of						Percent Change From
(in thousands)	September 30,		December 31,		September 30,		December 31,	September 30,
	2018		2017		2017		2017	2017
Commercial	$	353	$	-	$	382	N/M	(7.6)
Leases		-		610		1,031	(100.0)	(100.0)
Real estate-commercial, nonfarm		21,008		6,098		7,633	244.5	175.2
Real estate-commercial, farm		1,241		2,439		2,495	(49.1)	(50.3)
Real estate-construction		282		371		380	(24.0)	(25.8)
Real estate-residential:
Investor		1,103		436		648	153.0	70.2
Multifamily		3,177		-		4,757	N/M	(33.2)
Owner occupied		5,022		5,476		4,418	(8.3)	13.7
HELOC		1,829		2,038		1,977	(10.3)	(7.5)
Other 1		55		18		8	205.6	588
Total classified loans		34,070		17,486		23,729	94.8	43.6
Other real estate owned		6,964		8,371		9,024	(16.8)	(22.8)
Total classified assets, excluding PCI loans		41,034		25,857		32,753	58.7	25.3
PCI, net of purchase accounting adjustments		10,887		-		-	N/M	N/M
Total classified assets	$	51,921	$	25,857	$	32,753	100.8	58.5

N/M - Not meaningful

1 The “Other” class includes consumer and overdrafts.

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Classified loans include nonaccrual, performing troubled debt restructurings and all other loans considered substandard. Classified assets include both classified loans and OREO. Loans classified as substandard are inadequately protected by either the current net worth and ability to meet payment obligations of the obligor, or by the collateral pledged to secure the loan, if any. These loans have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt and carry the distinct possibility that the Company will sustain some loss if deficiencies remain uncorrected.

Total classified loans and total classified assets both increased as of September 30, 2018, from the levels at December 31, 2017 and September 30, 2017 due to loans purchased in our acquisition of ABC Bank in the second quarter of 2018. Management monitors a ratio of classified assets to the sum of Bank Tier 1 capital and the allowance for loan and lease losses as another measure of overall change in loan related asset quality, which is referred to as the “classified assets ratio.” The classified assets ratio was 13.48% for the period ended September 30, 2018.

Allowance for Loan and Lease Losses

Below is a reconciliation of the activity for loan losses for the periods indicated (in thousands):


		Three Months Ended								Nine Months Ended
	September 30,			June 30,			September 30,			September 30,			September 30,
	2018			2018			2017			2018			2017
Allowance at beginning of period	$	19,321		$	18,188		$	15,836		$	17,461		$	16,158
Charge-offs:
Commercial		7			15			13			38			20
Leases		-			8			98			13			215
Real estate - commercial		201			504			22			609			300
Real estate - construction		-			-			19			(16)			23
Real estate - residential		-			5			7			(55)			1,178
HELOC		49			65			82			141			262
Other 1		115			102			-			316			-
Total charge-offs		372			699			241			1,046			1,998
Recoveries:
Commercial		32			92			6			141			13
Leases		-			-			-			-			-
Real estate - commercial		37			21			43			425			124
Real estate - construction		32			-			11			35			89
Real estate - residential		83			105			459			1,099			850
HELOC		139			91			45			277			166
Other 1		56			73			6			208			13
Total recoveries		379			382			570			2,185			1,255
Net charge-offs / (recoveries)		(7)			317			(329)			(1,139)			743
Provision (release) for loan and lease losses		-			1,450			300			728			1,050
Allowance at end of period	$	19,328		$	19,321		$	16,465		$	19,328		$	16,465

Average total loans (exclusive of loans held-for-sale)	$	1,839,341		$	1,806,209		$	1,550,229		$	1,749,589		$	1,513,693
Net charge-offs / (recoveries) to average loans		(0.00)	%		0.02	%		(0.02)	%		(0.07)	%		0.05	%
Allowance at period end to average loans		1.05	%		1.07	%		1.06	%		1.10	%		1.09	%

Ending balance: Individually evaluated for impairment	$	373		$	498		$	6		$	373		$	6
Ending balance: Collectively evaluated for impairment	$	18,955		$	18,823		$	16,459		$	18,955		$	16,459
Ending balance: Acquired and accounted for ASC 310-30	$	-		$	-		$	-		$	-		$	-

1 The “Other” class includes consumer and overdrafts.

Net recoveries for the quarter ended September 30, 2018, totaled $7,000, compared to $329,000 of net recoveries for the quarter ended September 30, 2017. Net recoveries for the nine months ended September 30, 2018 were $1.1 million, compared to net charge-offs of $743,000 for the nine months ended September 30, 2017. The coverage ratio of the allowance for loan and lease losses to nonperforming loans was 164.1% as of September 30, 2018, which was an increase from the coverage ratio of 111.8% as of December 31, 2017, and 101.2% as of September 30, 2017. When measured as a percentage of average loans as of September 30, 2018, our total allowance for loan and lease losses decreased to 1.05% of quarterly average loans from 1.07% as of

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June 30, 2018, and 1.06% as of September 30, 2017. The total allowance for loan and lease losses as a percent of total period end loans was 1.05% as of September 30, 2018, excluding the loans purchased in our ABC Bank and Talmer branch acquisitions.

In accordance with the accounting guidance for business combinations, there was no allowance brought forward on any of the acquired loans in our acquisition of ABC Bank or our Talmer branch purchase. For non-PCI loans, credit discounts representing the principal losses expected over the life of the loan are a component of the initial fair value and the discount is accreted to interest income over the life of the loan. Subsequent to the purchase date, the method used to evaluate the sufficiency of the credit discount is similar to organic loans, and if necessary, additional reserves are recognized in the allowance for loan and lease losses. The aggregate non-PCI loans related to our acquisition of ABC Bank and the Talmer branch purchase totaled $304.6 million as of September 30, 2018, net of purchase accounting adjustments, which included $1.7 million of credit discounts. At September 30, 2018, of our $19.3 million allowance for loan and lease losses, $1.8 million related to non-PCI loans. In management’s judgment, an adequate allowance for estimated losses has been established for inherent losses at September 30, 2018, and general changes in lending policy, procedures and staffing, as well as other external factors. However, there can be no assurance that actual losses will not exceed the estimated amounts in the future, based on unforeseen economic events, changes in business climates and the condition of collateral at the time of default and repossession.

We recorded PCI loans in our acquisition of ABC Bank, which totaled $10.9 million, net of purchase accounting adjustments, which included $6.1 million of credit discounts as of September 30, 2018. We will perform re-estimations of cash flows on our PCI loan portfolio on a quarterly basis. Any decline in expected cash flows as a result of these re-estimations, due in any part to a change in credit, is deemed credit impairment, and recorded as provision for loan and lease losses during the period. Any decline in expected cash flows due only to changes in expected timing of cash flows is recognized prospectively as a decrease in yield on the loan and any improvement in expected cash flows, once any previously recorded impairment is recaptured, is recognized prospectively as an adjustment to the yield on the loan.

Other Real Estate Owned

As of September 30, 2018, OREO decreased to $7.0 million, compared to $8.4 million at December 31, 2017, and $9.0 million at September 30, 2017. There was one addition to the OREO portfolio in the third quarter of 2018. Property disposals in the third quarter of 2018 totaled $1.6 million due to five property sales. Valuation write-downs continued with an expense of $119,000 recorded on six properties in the third quarter of 2018, compared to $78,000 of valuation write-downs recorded in the fourth quarter of 2017, and $920,000 of valuation write-downs recorded in the third quarter of 2017.


							September 30, 2018
OREO	Three Months Ended						Percent Change From
(in thousands)	September 30,		December 31,		September 30,		December 31,	September 30,
	2018		2017		2017		2017	2017
Beginning balance	$	8,912	$	9,024	$	11,724	(1.2)	(24.0)
Property additions		(217)		-		176	N/M	(223.3)
Less:
Property disposals		1,612		575		1,956	180.3	(17.6)
Period valuation adjustments		119		78		920	52.6	(87.1)
Total other real estate owned	$	6,964	$	8,371	$	9,024	(16.8)	(22.8)

N/M - Not meaningful

In management’s judgment, the property valuation allowance as established presents OREO at current estimates of fair value less estimated costs to sell; however, there can be no assurance that additional losses will not be incurred on disposals or upon updates to valuations in the future. Of note, properties valued in total at $4.5 million, or approximately 65.3% of total OREO at September 30, 2018, have been in OREO for five years or more. The appropriate regulatory approval has been obtained for any OREO properties held in excess of five years.



OREO Properties by Type
(in thousands)	September 30, 2018				December 31, 2017				September 30, 2017
		Amount	% of Total			Amount	% of Total			Amount	% of Total
Single family residence	$	638	9	%	$	900	11	%	$	937	11	%
Lots (single family and commercial)		4,310	62	%		5,329	63	%		5,536	61	%
Vacant land		470	7	%		479	6	%		628	7	%
Commercial property		1,546	22	%		1,663	20	%		1,923	21	%
Total other real estate owned	$	6,964	100	%	$	8,371	100	%	$	9,024	100	%

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Deposits and Borrowings


							September 30, 2018
Deposits	As of						Percent Change From
(in thousands)	September 30,		December 31,		September 30,		December 31,	September 30,
	2018		2017		2017		2017	2017
Noninterest bearing demand	$	621,580	$	572,404	$	556,874	8.6	11.6
Savings		298,073		262,220		260,268	13.7	14.5
NOW accounts		437,361		429,448		417,054	1.8	4.9
Money market accounts		310,452		276,082		270,647	12.4	14.7
Certificates of deposit of less than $100,000		235,272		216,493		219,152	8.7	7.4
Certificates of deposit of $100,000 through $250,000		163,716		122,489		114,373	33.7	43.1
Certificates of deposit of more than $250,000		65,916		43,789		50,747	50.5	29.9
Total deposits	$	2,132,370	$	1,922,925	$	1,889,115	10.9	12.9

Total deposits were $2.13 billion at September 30, 2018, which reflects a $209.4 million increase from total deposits of $1.92 billion at December 31, 2017, and an increase of $243.3 million over the $1.89 billion at September 30, 2017. The growth in deposits was primarily due to our acquisition of ABC Bank, which added $248.5 million of deposits, net of purchase accounting adjustments. Total noninterest bearing demand accounts increased $49.2 million, or 8.6%, to $621.6 million at September 30, 2018, compared to noninterest bearing demand accounts of $572.4 million at December 31, 2017. Certificates of deposit reflected an increase of $82.1 million, or 21.5%, at September 30, 2018, compared to December 31, 2017, and savings, NOW and money market accounts reflected growth of 8.1% at September 30, 2018, compared to December 31, 2017. In addition to total deposit growth experienced related to our ABC Bank acquisition, an increase in noninterest bearing demand deposits in the third quarter of 2018 compared to the prior year end and year over year periods was attributable to strong commercial demand deposit growth stemming from operational fund increases as well as growth in commercial loan clients over the past year.

In addition to deposits, the Bank obtained funding from other sources in all periods presented. Securities sold under repurchase agreements totaled $44.3 million at September 30, 2018, a $14.4 million, or 48.2%, increase from $29.9 million at December 31, 2017. The Bank also recorded short-term advances of $81.9 million, primarily from the FHLBC at September 30, 2018, as compared to $115.0 million in short term borrowings outstanding from the FHLBC at December 31, 2017. The Bank also assumed $23.5 million of long-term FHLBC advances with the ABC Bank acquisition, with maturities scheduled over the next 7.5 years and paying interest at rates of 1.40% to 2.83%.

The Company is indebted on senior notes totaling $44.1 million, net of deferred issuance costs, which were issued in the fourth quarter of 2016. These notes mature in December 2026, and include interest payable semi-annually at 5.75% for five years. Beginning December 2021, the interest becomes payable quarterly at three month LIBOR plus 385 basis points. The Company is also indebted on $57.7 million, net of deferred issuance costs, of junior subordinated debentures, which are related to the trust preferred securities issued by its two statutory trust subsidiaries, Old Second Capital Trust I and Old Second Capital Trust II (“Trust II”). The Trust II issuance converted from fixed to floating rate at three month LIBOR plus 150 basis points on June 15, 2017. Upon conversion to a floating rate, we initiated a cash flow hedge which resulted in the total interest rate paid on this debt of 4.34% as of September 30, 2018, as compared to 6.77%, which was the rate paid during the period prior to the June 15, 2017 rate reset.

Capital

As of September 30, 2018, total stockholders’ equity was $218.1 million, which was an increase of $17.8 million from $200.4 million as of December 31, 2017. This increase is directly attributable to net income of $25.4 million for the first nine months of 2018, partially offset by a change in accumulated other comprehensive net loss of $7.5 million, and $892,000 of dividends paid to common stockholders in 2018 year to date.

The Company’s total stockholders’ equity continues to include $4.8 million related to the value of a ten-year warrant to purchase shares of our common stock, with an exercise price of $13.43 per share. This warrant was issued in January 2009 as part of the Company’s Series B preferred stock issuance; all preferred stock issued was redeemed as of September 30, 2015. A discussion of the 2009 issuance, including this warrant, is included in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of the Company’s Form 10-K for the year ended December 31, 2017, under the heading “Capital”.

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The following table shows the regulatory capital ratios and the current well capitalized regulatory requirements for the Company and the Bank as of the dates indicated:


			September 30,		December 31,		September 30,
	Well-Capitalized1		2018		2017		2017
The Company
Common equity tier 1 capital ratio	N/A		9.12	%	9.25	%	8.88	%
Total risk-based capital ratio	N/A		12.57	%	12.93	%	12.46	%
Tier 1 risk-based capital ratio	N/A		11.67	%	12.03	%	11.54	%
Tier 1 leverage ratio	N/A		9.72	%	10.08	%	9.69	%

The Bank
Common equity tier 1 capital ratio	6.50	%	13.26	%	12.88	%	12.67	%
Total risk-based capital ratio	10.00	%	14.16	%	13.78	%	13.52	%
Tier 1 risk-based capital ratio	8.00	%	13.26	%	12.88	%	12.67	%
Tier 1 leverage ratio	5.00	%	11.05	%	10.79	%	10.63	%

1 Represents ratios required to be considered well capitalized under prompt corrective action provisions. The prompt corrective action provisions are only applicable at the Bank level.

The Company, on a consolidated basis, exceeded the minimum capital ratios to be deemed “well capitalized” as of September 30, 2018, pursuant to the capital requirements in effect at that time. All ratios conform to the regulatory calculation requirements in effect as of the date noted. In addition to the above regulatory ratios, the Company’s GAAP common equity to asset ratio, which is used as a performance measurement for capital analysis and peer comparisons, decreased from 8.41% at December 31, 2017 to 8.35% at September 30, 2018, due to the ABC Bank acquisition. The Company’s non-GAAP tangible common equity to tangible assets ratio, which management also considers a valuable performance measurement for capital analysis, decreased from 8.07% at December 31, 2017, to 7.60% at September 30, 2018; the reduction was due to intangibles of $13.0 million recorded related to the Company’s acquisition of ABC Bank in the second quarter of 2018.

Reconciliation of Tangible Common Equity to Tangible Assets Ratio Non-GAAP Measure

The Company’s GAAP tangible common equity to tangible assets ratio was 7.57% at September 30, 2018, compared to 8.06% as of December 31, 2017.


	September 30, 2018						December 31, 2017
(in thousands)	GAAP			Non-GAAP			GAAP			Non-GAAP
Tangible common equity
Total Equity	$	218,130		$	218,130		$	200,350		$	200,350
Less: Goodwill and intangible assets		21,947			21,141			8,922			8,813
Tangible common equity	$	196,183		$	196,989		$	191,428		$	191,537
Tangible assets
Total assets	$	2,612,473		$	2,612,473		$	2,383,429		$	2,383,429
Less: Goodwill and intangible assets		21,947			21,141			8,922			8,813
Tangible assets	$	2,590,526		$	2,591,332		$	2,374,507		$	2,374,616

Common equity to total assets		8.35	%		8.35	%		8.41	%		8.41	%
Tangible common equity to tangible assets		7.57	%		7.60	%		8.06	%		8.07	%

The non-GAAP intangible asset exclusion reflects the 80% core deposit limitation per Basel III guidelines within risk based capital calculations, and is useful for the Company when reviewing risk based capital ratios and equity performance metrics.

Liquidity

Liquidity is the Company’s ability to fund operations, to meet depositor withdrawals, to provide for customers’ credit needs, and to meet maturing obligations and existing commitments. The liquidity of the Company principally depends on cash flows from operating activities, investment in and maturity of assets, changes in balances of deposits and borrowings, and its ability to borrow funds. The Company monitors its borrowing capacity at the FHLBC as part of its liquidity management process as supervised by the Asset and Liability Committee (“ALCO”) and reviewed by the Board of Directors.

Net cash inflows from operating activities were $40.0 million during the first nine months of 2018, compared with net cash inflows of $28.5 million in the same period in 2017. Proceeds from sales of loans held-for-sale, net of funds used to originate loans held-for-sale,

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were a source of inflows for the first nine months of 2018 and 2017. Interest paid, net of interest received, combined with changes in other assets and liabilities were a source of inflows for the first nine months of 2018 and outflows for the like 2017 period. The management of investing and financing activities, as well as market conditions, determines the level and the stability of net interest cash flows. Management’s policy is to mitigate the impact of changes in market interest rates to the extent possible, as part of the balance sheet management process.

Net cash inflows from investing activities were $35.4 million in the first nine months of 2018, compared to net cash outflows of $105.7 million in the same period in 2017. In the first nine months of 2018, securities transactions accounted for net inflows of $57.3 million, and the principal change on loans accounted for net inflows of $10.0 million. Proceeds from claims on BOLI, net of premiums paid, accounted for net inflows of $1.2 million. In the first nine months of 2017, securities transactions accounted for net inflows of $8.4 million, and net principal disbursed on loans accounted for net outflows of $118.7 million. Proceeds from sales of OREO accounted for $4.3 million and $5.5 million in investing cash inflows for the first nine months of 2018 and 2017, respectively. Cash outflows for the nine months ended September 30, 2018, included cash paid for the Company’s purchase of ABC Bank of $35.7 million, net of cash and cash equivalents retained.

Net cash outflows from financing activities in the first nine months of 2018 were $81.0 million, compared with net cash inflows of $77.3 million in the first nine months of 2017. Net deposit outflows in the first nine months of 2018 were $39.1 million compared to net deposit inflows of $22.3 million in the first nine months of 2017. Other short-term borrowings had net cash outflows of $44.0 million in the first nine months of 2018 and inflows of $55.0 million in the first nine months of 2017. Changes in securities sold under repurchase agreements accounted for $8.8 million and $1.1 million in net inflows in the first nine months of 2018 and 2017, respectively.

Cash and cash equivalents for the nine months ended September 30, 2018, totaled $50.3 million, as compared to $47.5 million as of September 30, 2017.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Interest Rate Risk

As part of its normal operations, the Company is subject to interest-rate risk on the assets it invests in (primarily loans and securities) and the liabilities it funds with (primarily customer deposits and borrowed funds), as well as its ability to manage such risk. Fluctuations in interest rates may result in changes in the fair market values of the Company's financial instruments, cash flows, and net interest income. Like most financial institutions, the Company has an exposure to changes in both short-term and long-term interest rates.

In September 2018, the Federal Reserve raised short-term interest rates by 0.25%. There is a general market expectation that the Federal Reserve will continue to move short-term interest rates higher during 2018 and potentially into 2019. Generally, Federal Reserve actions have not had a significant impact on long-term rates, although Federal Reserve officials began ending their reinvestment of their securities portfolio cash flow in October 2017 which could result in increases in long-term rates if federal budget deficits continue to increase. The Company manages interest rate risk within guidelines established by policy which limits the amount of rate exposure. In practice, we intend to maintain interest rate risk exposure well within those guidelines so it is not expected to pose a material risk to the future earnings of the Company.

The Company manages various market risks in its normal course of operations, including credit, liquidity risk, and interest-rate risk. Other types of market risk, such as foreign currency exchange risk and commodity price risk, do not arise in the normal course of the Company's business activities and operations. In addition, since the Company does not hold a trading portfolio, it is not exposed to significant market risk from trading activities. The Company's interest rate risk exposures at September 30, 2018 and December 31, 2017 are outlined in the table below.

The Company's net income can be significantly influenced by a variety of external factors, including: overall economic conditions, policies and actions of regulatory authorities, the amounts of and rates at which assets and liabilities reprice, variances in prepayment of loans and securities other than those that are assumed, early withdrawal of deposits, exercise of call options on borrowings or securities, competition, a general rise or decline in interest rates, changes in the slope of the yield-curve, changes in historical relationships between indices (such as LIBOR and prime), and balance sheet growth or contraction. The Company's ALCO seeks to manage interest rate risk under a variety of rate environments by structuring the Company's balance sheet and off-balance sheet positions, which includes interest rate swap derivatives as discussed in Note 15 of the financial statements included in this quarterly report. The risk is monitored and managed within approved policy limits.

The Company utilizes simulation analysis to quantify the impact of various rate scenarios on net interest income. Specific cash flows, repricing characteristics, and embedded options of the assets and liabilities held by the Company are incorporated into the simulation model. Earnings at risk is calculated by comparing the net interest income of a stable interest rate environment to the net interest income of a different interest rate environment in order to determine the percentage change. As of December 31, 2017, the Company

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had modest amounts of earnings gains (in both dollars and percentage) should interest rates rise, and limited earnings reductions should interest rates fall. The changes in income across the various interest rate scenarios as of September 2018 were similar to those of December 2017, with the exception of the -2.00% scenario which showed a notable increase in falling rate exposure. This change was largely due to the Company's implementation of more advanced software to measure the impact of interest rate changes on earnings. This software more accurately assesses the impacts of rate changes on instruments such as callable bonds of state and political subdivisions that comprise a significant proportion of the Company's investment portfolio. The general balance sheet composition, both assets and liabilities, did not change appreciably during the quarter, which resulted in little change to the Company's interest rate risk profile. Overall, management considers the current level of interest rate risk to be moderate, but intends to continue closely monitoring changes in that risk in case corrective actions might be needed in the future. The Federal Funds rate and the Bank's prime rate increased by 0.25% during the quarter to 2.00% and 5.00%, respectively.

The following table summarizes the effect on annual income before income taxes based upon an immediate increase or decrease in interest rates of 0.5%, 1%, and 2% and no change in the slope of the yield curve.


	Analysis of Net Interest Income Sensitivity
(dollars in thousands)	Immediate Changes in Rates
		(2.0)	%		(1.0)	%		(0.5)	%		0.5	%		1.0	%		2.0	%
September 30, 2018
Dollar change	$	(15,434)		$	(7,424)		$	(3,314)		$	1,725		$	3,349		$	6,605
Percent change		(15.7)	%		(7.6)	%		(3.4)	%		1.8	%		3.4	%		6.7	%

December 31, 2017
Dollar change	$	(9,447)		$	(5,272)		$	(2,382)		$	1,375		$	2,764		$	5,273
Percent change		(12.0)	%		(6.7)	%		(3.0)	%		1.7	%		3.5	%		6.7	%

The amounts and assumptions used in the simulation model should not be viewed as indicative of expected actual results. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and management strategies. The above results do not take into account any management action to mitigate potential risk.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

The Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures, as defined in Rule 13a-15(e) promulgated under the Securities and Exchange Act of 1934, as amended, as of September 30, 2018. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that as of September 30, 2018, the Company’s internal controls were effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Securities and Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified.

There were no changes in the Company’s internal controls over financial reporting during the quarter ended September 30, 2018, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

The design of any system of controls and procedures is based in part upon certain assumptions about the likelihood of future events. There can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote.

PART II - OTHER INFORMATION

Item 1. Legal Proceedings

The Company and its subsidiaries, from time to time, are involved in collection suits in the ordinary course of business against its debtors and are defendants in legal actions arising from normal business activities. Management, after consultation with legal counsel, believes that the ultimate liabilities, if any, resulting from these actions will not have a material adverse effect on the financial position of the Bank or on the consolidated financial position of the Company.

Item 1.A. Risk Factors

There have been no material changes from the risk factors set forth in Part I, Item 1.A. “Risk Factors,” of the Company’s Form 10-K for the year ended December 31, 2017.

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Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

None.

Item 3. Defaults Upon Senior Securities

None.

Item 4. Mine Safety Disclosures

Not applicable

Item 5. Other Information

None.

Item 6. Exhibits

Exhibits:






10.1	Restated Old Second Bancorp, Inc. 2014 Equity Incentive Plan (restated to combine the 2014 Equity Incentive Plan included
	as Appendix A to the Company’s Proxy Statement filed on Form DEFA filed on April 21, 2014 and the First Amendment
	thereto and to correct a scrivener’s error in such First Amendment included as Appendix A to the Company’s Proxy
	Statement filed on Form DEFA filed on April 12, 2016.)

31.1	Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a).

31.2	Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a).

32.1	Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2	Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

101	Interactive data files pursuant to Rule 405 of Regulation S-T: (i) Consolidated Balance Sheets at September 30, 2018, and December 31, 2017; (ii) Consolidated Statements of Income for the nine months ended September 30, 2018 and 2017; (iii) Consolidated Statements of Stockholders’ Equity for the nine months ended September 30, 2018 and 2017; (iv) Consolidated Statements of Cash Flows for the nine months ended September 30, 2018 and 2017; and (v) Notes to Consolidated Financial Statements, tagged as blocks of text and in detail.*

	* As provided in Rule 406T of Regulation S-T, these interactive data files shall not be deemed “filed” for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934 as amended, or otherwise subject to liability under those sections.

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SIGNATURES

Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


	OLD SECOND BANCORP, INC.


		BY:	/s/ James L. Eccher
			James L. Eccher
			President and Chief Executive Officer
			(principal executive officer)


		BY:	/s/ Bradley S. Adams
			Bradley S. Adams
			Executive Vice President and Chief Financial Officer
			(principal financial and accounting officer)


DATE: November 7, 2018